New Zealand’s interest up 25 basis points but is it still stimulatory?

Today, not surprisingly, the RBNZ increased the official cash rate (OCR) by 25 basis points – 0.25% – to 1%. There was a suggestion in the RBNZ Monetary Statement that the increase could be 50 basis points but noted a preparedness to move in bigger steps than 25bp if required”. The RBNZ forecast endpoint for the OCR has been increased to 3.35%. and expect annual CPI inflation to peak at 6.6% in the March 2022 year and to fall back to the 1-3% inflation midpoint by mid 2024. The reduction in inflation should come from the easing of supply chain disruptions, lower commodity prices and tradable inflation. But the question that needs to be asked is, will this tightening be sufficient to dampen the following:

  • domestic pressure from the housing market,
  • wage pressure with 5.9% inflation and unemployment at a very low 3.2%,
  • prices of locally produced products (non-tradable inflation)

The Neutral Interest Rate

Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.

The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.

OCR > Neutral Rate = Contractionary and slowing down the economy
OCR < Neutral Rate = Expansionary and speeding up the economy

The RBNZ’s  estimate of the neutral OCR is between 0.9% and 3.1% – see below.  Like many other countries, the neutral cash rate in NZ is estimated to have been declining over many years.

OCR - Neutral Rate

Since the GFC neutral rates around the world have been falling which reflects the following:

  1.  Lower expectations about growth in the economy = reduces the return to investment
  2.  Relative to pre-GFC, a wider spread between the central bank rate and the interest rates faced by households and businesses (i.e. mortgages and business lending rates).
  3. An increase in global desired savings. For instance, demographic trends offshore have led to an increase in saving among the cohort of the population going through prime earning years (as they save for retirement). Likewise, increased income inequality is thought to increase desired savings, as top income earners typically have a lower marginal propensity to consume – MPC.
  4. Higher debt ratios in some countries (including NZ) make the economy more sensitive to interest rate increases than before.

Central Banks don’t have the independence to set the neutral rate as it is very much influenced by global forces. However they do have independence as to where they set their policy rate relative to the neutral rate.

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