The RBNZ's view on the neutral interest rate highlights a risk it thinks current monetary policy settings 'are more stimulatory than they actually are'

The neutral interest rate, the dividing line between where interest rates are stimulating or constraining economic activity, remains 4.5%, according to the Reserve Bank.

This is the conclusion drawn in a Reserve Bank Analytical Note entitled Estimating New Zealand's neutral interest rate, by Adam Richardson and Rebecca Williams.

It's something of a surprise that the Reserve Bank has retained this view, which the central bank has had since October 2013, given both Governor Graeme Wheeler and Assistant Governor John McDermott have recently hinted the Reserve Bank may lower its view of what the neutral interest rate is.

"Estimates suggest the nominal neutral 90-day interest rate sits between 3.8 and 4.9 percent currently," Richardson and Williams say. "The mean of these indicators is 4.3 percent. The Bank currently judges that the nominal neutral 90-day interest rate sits at 4.5 percent - within the range of estimates and close to the mean of these estimates."

"This implies that current monetary policy settings are expansionary, although these models highlight some emerging risk that the neutral interest rate is falling further," Richardson and Williams added. "The Bank will continue to monitor the validity of these assumptions when considering policy settings."

They go on to say interest rates that are most important for influencing behaviour are the ones actually faced by businesses and households.

"In this regard, the floating mortgage rate is an important benchmark rate that the Bank monitors when it sets policy. The nominal neutral floating mortgage rate is currently assumed to be 7 percent, having been lowered by 100 basis points over 2008 and 2009."

'A neutral 90-day bank bill rate is currently under 3.5%'

ASB senior economist Chris Tennent-Brown said the Reserve Bank could've lowered its view, and not doing so highlights a risk the Reserve Bank thinks current monetary policy settings are more stimulatory than they actually are.

"In essentially sticking with the 4.5% neural view, the implication is the Reserve Bank views the current 90-day rate of 2.84% as very stimulatory, and were stimulatory before the Bank commenced its easing cycle in June this year.  In contrast we think that a neutral 90-day bank bill rate is currently under 3.5%, implying that interest rate settings were neutral, possibly even slightly restrictive, before the 2015 easing cycle began, and have only just moved into stimulatory territory over recent months," Tennent-Brown said.

"In saying that, the Reserve Bank does acknowledge that the models highlight an 'emerging risk that the neutral interest rate is falling further'. Today’s paper doesn’t change our view that the Reserve Bank needs to cut the OCR further (from 2.75%). In our view though, the paper highlights a risk that the Reserve Bank thinks current policy settings are more stimulatory than they actually are," said Tennent-Brown.

'A true read requires the removal of the LVR restrictions'

The Reserve Bank's view did, however, get more sympathy from BNZ senior economist Craig Ebert.

"Anyone excited that the Bank might drop its estimate of what a neutral short-term NZ interest rate is these days would have been sorely disappointed. Yes, the paper, in running through a range of neutrality methods and measures, did infer a declining path since before GFC (Global Financial Crisis). However, still only a very mild downward trend. And so not quite to the point of tipping the bank’s neutral OCR estimate to 4.00%," Ebert said.

BNZ's economists agree with the Reserve Bank's line of thinking, Ebert added.

"We believe too many people have been too quick to over-extend the tendency toward a 'new-normal' on interest rates. Yes, the new equilibria are probably materially lower than they were 10 to 20 years ago, for a range of entirely valid reasons. However, there is a limit. And it’s far from zero. For those pointing to the lack of credit growth as a counter-example we would point out that 1) New Zealand’s is, in fact, picking up and 2) to get a true read on the force of current interest rate settings one would need to remove the Reserve Bank’s LVR (loan-to-value ratio) restraint. Then we could easily imagine household credit growth well in excess of 10% per annum," said Ebert.

Although the Analytical Note says the views expressed are those of the authors and don't necessarily represent the Reserve Bank's views, at this month's Monetary Policy Statement press conference Wheeler said this note was coming, and it would, "give all the details about how we measure neutral, (and) what our best view is at the moment."

Richardson is an adviser in the Reserve Bank's policy analysis team, and Williams is a senior analyst in the issues team.