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

Reserve Bank of Australia likely to ease cash rate

With continued global weakness the RBA is becoming increasingly worried about the prospects for the Australian economy. According to the National Bank of Australia there are 3 factors that the RBA are concerned with:

1. Although house prices are stabilising there are some sectors of the economy that remain in a depressed state – residential construction has a record low capacity utilisation (see graph).
2. A tightening of state and federal fiscal policy has meant that there is less aggregate demand in the economy.
3. The high value of the AUS$ affects the competitiveness of exports. However business now see the high AUS$ as permanent rather than cyclical. This is important as the RBA is not expecting lower rates to significantly lower the AUS$ but rather is trying to offset some of the economic damage to the economy.

It could be that a rate cut by the RBA is an insurance policy in an environment where inflation appears stable. The graph below looks at the RBA Cash Rate and the Taylor Rule.

The Taylor Rule

This is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. Taylor argued that when:

Real Gross Domestic Product (GDP) = Potential Gross Domestic Product and
Inflation = its target rate of 2%,

then the Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).

If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 0.5%.

This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.

Kangaroo economy needs a bit of a jump start

Last week the Reserve Bank of Australia cut interest rates by 50 basis points. They cut rates from 4.25 per cent to 3.75 per cent – the biggest move since the peak of the global financial crisis in early 2009. This is a rather large cut by international standards as increases and decreases in the rates of central banks worldwide tend to be 25 basis points. However the RBA is worried about the lack of impact on domestic demand and confidence that cuts had last year. Therefore they felt that a more significant cut was warranted to stimulate more growth in the economy.

Also the RBA are worried about the strength of the AUS$ and the impact it is having on manufacturing and service exports. Although the mining sector is going along quite nicely there is concern about the domestic service and non-mining sectors as investment has been quite weak. Other data has showed that house prices have fallen 1.1% in the first quarter of 2012 and that lending rates have risen 0.1% and the cut in the cash rate will probably not be passed on to those borrowing.

Although some say that the RBA might be ‘behind the play’ you do have to remember that in Australia (unlike NZ and other economies) they don’t have monthly CPI figures but quarterly. Therefore they have to wait for a quarterly result to have any idea of where inflation is heading.

Reserve Bank of Australia rate cut – not like cockroaches

Yesterday the RBA cut its key cash rate for the first time since 7th April 2009 – the last rates move was exactly a year ago (2nd November 2010) when rates went up by 0.25% to 4.75%. The cut amounted to 0.25% which leaves the key rate at 4.5% – a very high rate by international standards. The graph below shows that the US, Euro zone, and Japan have engaged in an aggressive expansionary monetary policy by lowering interest rates. Whilst Australia has experienced higher interest rates as its economy has grown at rate which has put pressure on its productive capacity and ultimately inflation.

Typically the RBA has cut or increased interest rates over a long period of time so are further cuts to follow? Sydney Morning Hearld economics correspondent Peter Martin likened these series of cuts/increases to cockroaches – there is never one of them. However he believes that this cut is a one-off and that the RBA has reached its neutral interest rate – that rate which is neither expansion or contractionary to the Australian economy. Here is the last paragraph of RBA Glenn Stevens’ statement:

Over the past year, the Board has maintained a mildly restrictive stance of monetary policy, in view of its concerns about inflation. With overall growth moderate, inflation now likely to be close to target and confidence subdued outside the resources sector, the Board concluded that a more neutral stance of monetary policy would now be consistent with achieving sustainable growth and 2–3 per cent inflation over time.

Aussies raise interest rates

The Reserve Bank of Australia (RBA) raised the cash rate yesterday by 25 basis points to 4.75%. This highlights the strength of the Australian economy and the requirement to take on-baord inflationary pressures. The RBA targets inflation between 2 – 3%. Below is part of the statement issued by the RBA.

However, the economy is now subject to a large expansionary shock from the high terms of trade and has relatively modest amounts of spare capacity. Looking ahead, notwithstanding recent good results on inflation, the risk of inflation rising again over the medium term remains. At today’s meeting, the Board concluded that the balance of risks had shifted to the point where an early, modest tightening of monetary policy was prudent.