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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What determines the Neutral Rate of Interest?

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

This neutral rate dictates when the RBNZ end their tightening or loosening cycle. If the neutral rate is seen to be 3% it is the expectation that the RNBZ will increase the OCR to 3%. The graph below shows the difference between the estimated neutral rate and the OCR. Note that:

2008 – positive gap as RBNZ trying to bring inflation under control – contractionary level
2019 – the gap narrows and monetary policy becomes less stimulatory as the neutral of the OCR is likely lower.

What determines the neutral rate of interest in an economy?

Supply of loanable funds (people who save money) and Demand to borrow money – neutral rate generates a level of savings and borrowing that delivers the economy to maximum sustainable employment and inflation – 2% in NZ but with Policy Target Agreement of 1-3%.
Potential growth rate of an economy – if people expect more growth = higher incomes = higher borrowing = upward pressure on neutral rates. Economists tend to look at the production function and how much we can produce in the long-run therefore impacting aggregate supply. With higher potential growth rates investment spending is expected to increase and with it interest rates.
Population growth – strong population growth = larger labour force = larger national output which supports the neutral rate of interest.
Age and life expectancy – higher life expectancy increases the amount that people save during their working years. If consumers buy now rather than later = potentially either lower saving rates and/or higher borrowing = neutral rate of interest rises.
Superannuation / retirement age – burden of funding retirees fall on a smaller working age population. This could require higher taxes which leads to less spending putting downward pressure on interest rates.
Debt – with low mortgage rates, debt servicing have been at record lows. People have therefore borrowed a lot money and now have high level of indebtedness levels. Therefore higher mortgage rates mean that consumers disposable income will be reduced.
Government debt – COVID-19 has led to increased government spending and bigger budget deficits. New Zealand economy is probably as sensitive to higher interest rates and an increase in rates by the RBNZ will be very influential, limiting how far interest rates have to rise. And with households and the Government already loaded up on debt, future borrowing capacity is now reduced, which will put downwards pressure on interest rates too.
Overseas investment – as New Zealand comes a more attractive place to invest it increase the supply of loanable funds to New Zealanders. The investment will also strengthen the dollar which make exports less competitive but imports cheaper. Global capital flows mean that we can’t get too far out of sync with other advanced economies – as long as global neutral rates continue their relentless move south, so too will New Zealand’s.

Outlook
With the COVID-19 lockdown, increasing levels of debt amongst households and business and record low interest rates there is an expectation the RBNZ will increase the OCR. But with the OCR at such a low level already the RBNZ is running out ammunition if it wishes to stimulate the economy through conventional monetary policy.

Source: NZ Insight: Neutral interest rates – 20th August 2021 – ANZ Bank

New Zealand’s Neutral Rate of Interest

A speech delivered last July by John McDermott (Assistant Governor and Head of Economics at the RBNZ) talked about the neutral rate of interest. 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 last published estimate of the neutral OCR was in June 2017 at 3.5%, with a range of estimates around that between 2.6% to 4.6%. Like many other countries, the neutral cash rate in NZ is estimated to have been declining over many years.

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.

Source: BNZ – Interest Rate Research – 14th June 2018

Reserve Bank of Australia – Neutral Rate

An article in the Sydney Morning Herald last month looked the Reserve Bank of Australia (RBA) and the neutral interest rate. For almost a year the RBA has kept Australia’s official interest rate at 1.5% and uses this instrument to control the overnight cash rate to try to manage the economic activity of an economy. EG.

Expansionary = Lower interest rates = encourages borrowing and spending
Contractionary = Higher interest rates = slows the economy down with less spending

How do we know that 1.5% is either expansionary or contractionary? Central banks indicate what they believe is the neutral rate of interest – this is a rate which is defined as neither expansionary or contractionary. In Australia the neutral is estimated to have fallen from 5% to 3.5% since the GFC. RBA deputy governor, Dr Guy Debelle, explains that the neutral rate aligns the amount of nation’s saving with the amount of investment, but does so at a level consistent with full employment and stable inflation. In Australia this equates to 5% unemployment and 2-3% inflation.

Aus - Neutral rate

The level of a country’s neutral interest rate will change with changes in the factors that influence saving and investment.

More saving will tend to lower interest rates
More investment will tend to increase interest rates

Debelle indicates that you can group these factors into 3 main categories:

1.The economy’s ‘potential’ growth rate – the fastest it can grow without impacting inflation.
2. The degree of ‘risk’ felt by households and firms. How confident do they feel about investing. Since the GFC people are more inclined to save.
3. International factors – with the free movement of capital worldwide global interest rates will influence domestic interest rates.

“We don’t have the independence to set the neutral rate, which is significantly influenced by global forces. But we do have independence as to where we set our policy rate relative to the neutral rate.” Dr Guy Debelle

RBNZ rate increase towards neutrality

With the recent increase in the OCR by 25 basis points to 3% interest rates are now heading to towards a neutral rate – one that is neither contractionary or expansionary. The macroeconomic indicators reflect the following:

* Annual inflation at 1.5% is not that far from the mid- point of the RBNZ target band, especially considering the temporary effect that an appreciating currency has on headline inflation. See graph below from BNZ.

* The economy has limited spare capacity – capacity utilisation is close to long term average and firms are having more difficulty than normal in finding labour.

* Economic growth is above trend and looks set to push further above trend this year.

These economic indicators suggest that the economy is in reasonable shape and will be able to avoid a severe correction over the nest couple of years.

NZ CPI

Central Banks and Neutral Rates

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.

In most economies post GFC the neutral rate of interest fell as they have required lower rates to try and encourage growth. See table below of current rates of Central Banks and approximate neutral rates.

CB Interest Rate Nov 13

What indicators shoud you look at as to whether neutral interest rates might have changed? Here are 4 that are identified by John McDermott, Assistant Governor of the Reserve Bank of New Zealand:

1. World Conditions

Gowth of the major trading partners of any country can put pressure on aggregate demand which consequently causes inflationary conditions. With this and inflatinary expectations there could be pressure on a central bank to increase interest rates

2. Domestic productivity growth

A continued decrease in productivity growth will lower returns to investment, whcih means that investment is less attractive. If the desire to invest falls and the desire to save remains unchanged, a lower neutral interest rate will be required reconcile savings and investment plans.

3. Population growth

Lower population growth decreases the number of people in the labour force, meaning less investment is needed to provide the necessary capital stock to employ the average labour force. As investment falls, a lower neutral interest rate – the one that equalises the supply of and demand for funds – will be required.

4. Preferences for savings and investment

If people decide to save more and consume less a lower interest rate would be required to boost the pace of activity and inflation and reconcile saving and investment plans.

An implication of a lower neutral interest rate is that households and businesses will face lower interest rates ‘on average’, but this should not be read as a promise of lower interest rates all the time. Interest rates will need to be adjusted in response to the state of the economy. For times when demand in the economy is expanding more rapidly than the economy’s ability to meet that demand interest rates will need to be above neutral. Moreover, there is no reason to suppose how far interest rates move from trough to peak will be any different in the next business cycle than they moved in previous cycles. John McDermott, Assistant Governor of the Reserve Bank of New Zealand