Where is the neutral Official Cash Rate?
The neutral OCR is where the Reserve Bank has the foot on neither the accelerator nor the brake.
It is an important number. It is where the OCR should sit on average to achieve stable inflation and helps define an average level for borrowing rates.
It also helps define the stance of monetary policy and the degree to which they are tapping the brake or have the foot on the accelerator.
It is also unobservable. We do not know what the number is.
There is some evidence it is now rising. If this is the case, borrowing rates will sit higher across the economic cycle in a sustained fashion, not just temporarily higher because the Reserve Bank is fighting inflation.
According to the Reserve Bank, the neutral OCR has trended down over several decades.
Back in 2000, the neutral OCR was estimated to be around 5%. By 2019 it had fallen to 2%. Other countries saw similar shifts. Interest rates did not need to be as high to achieve inflation objectives.
A fall in the neutral OCR helped shift longer term interest rates (think of a 10-year bond yield) and borrowing interest rates lower and lower over time. Falling bond yields saw investors chasing yield, which drove up asset prices.
Why?
A lot of global research notes that estimates of global neutral interest rates have been declining since the 1980s.
The Reserve Bank pointed to a range of factors in its November Monetary Policy Statement, including “demographic change, lower productivity growth, and changes in consumers’, businesses’, and governments’ attitudes towards savings and investment”.
We had a global surplus of capital and abundant saving. Think of it as a global savings glut.
Declining inflation expectations over a long period also played a role. The neutral OCR did not need to be as high.
Many investors are waiting for interest rate hikes to be followed by cuts as central banks return interest rates to a more neutral setting in years to come.
Some argue that secular stagnation or a sustained period of persistently slower growth is here. That argues for continued low neutral interest rates and actual interest rates returning lower after the battle against inflation.
Some say the neutral interest rates will rise if productivity growth increases. They point to the need for investment and note that the full benefits of technologies such as artificial intelligence hasn’t yet appeared.
With inflation elevated and well above 2%, it seems inconceivable the neutral OCR in New Zealand or other countries could be 2% percent. The real or inflation-adjusted OCR would be hugely negative!
Covid-19 and the war in Ukraine are large structural shifts that could shift the global economy in many ways. The era of globalisation is being replaced by nationalism. Climate change adds to costs and inflation. Will governments rein in spending?
The era of low and declining inflation is being replaced by a huge battle to contain it.
The Reserve Bank is flagging shifts.
The neutral OCR can be expressed in nominal or real (inflation adjusted) terms and expressed in the long run or short run.
They give different answers. Long-run estimates using the inflation target of 2% say not much has changed; the neutral OCR is still 2%. Conversely, short-run measures using near-term inflation expectations suggest the neutral OCR is a lot higher than 2%.
A combination of the two (the Reserve Bank call this a forecast horizon neutral OCR) has risen from 2.1% to 2.9% with a confidence bound around those numbers. That is a big shift.
The bottom line is that actual borrowing rates fell over time in part because neutral interest rates declined. They declined to levels that implied the real or inflation-adjusted level was basically zero (2% OCR less 2% inflation).
Among all the economic wizardry to justify lower rates than we have seen for the past two decades, maybe we just got lucky on the inflation front and that defined where the likes of the neutral OCR ended up. Our luck on the inflation front has now run out.
Our luck on the inflation front has now run out. We face a battle to contain it, and I expect to see estimates of neutral interest rates rise. That will define the degree to which interest rate hikes can be followed by cuts.
