New Zealand’s Reserve Bank is to publish an analytical note on what a neutral interest rate should sit at in the future.

The confirmation comes as this week, the Bank of Japan’s Institute for Monetary and Economic Studies hosts a conference of central bankers from around the world.

Reserve Bank chief economist Paul Conway is there, and says neutral interest rates are an important discussion. In essence, an interest rate is neutral if it’s neither expansionary nor contractionary – that’s been pegged at about 2 percent in New Zealand.

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“It’s a debate. That’s what I’m hoping to learn about,” he says. “There are international economists who see good reason for neutral rates increasing compared to what they have been over recent years.

“Neutral rates have been falling for the last few decades, at least. There are some economists who think that’s going to change, but it’s an active debate. Some argue they are going to stay pretty low. So I don’t have a definitive answer for you on that.”

Last week, in its monetary policy statement, the Reserve Bank projected continuing low economic growth through 2023 and 2024, but then picking up again as the world’s central banks return inflation to target interest rates to neutral levels. It’s already indicated, though, that short-term nominal neutral interest rate increased last year.

“I would say that it’s clear to us that mortgage rates and interest rates more generally in the economy are now above neutral, and having the desired contractionary effect. And that’s one of the reasons why we’re confident that we will get on top of inflation over the coming quarters.”

OCR and nominal neutral OCR indicator suite (quarterly average)

The shaded area indicates the range between the maximum and minimum values from the Reserve Bank’s suite of long-run nominal neutral OCR indicators. Source: RBNZ

The existing interest rates projection extends out only a few years, and projects that the official cash rate will begin to fall from the present high rate of 5.5 percent. And that will feed through into retail interest rates. 

“Beyond that, in long run equilibrium, we don’t currently have an increase in neutral rates factored into our predictions,” Conway says. “This is an active area of research. And part of the reason I’m in Japan today is to learn more about what the best brains in the global economics community are thinking on this important issue.”

Former International Monetary Fund chief economist Maurice Obstfeld has delivered a paper at the conference – and he’s one of those who’s skeptical the pandemic changed everything.

He argues real interest rates have been declining since the 1990s, especially in Asia, for reasons including aging societies spurring demand for safe assets, slackening global growth, and the replenishing of reserves in emerging markets. “Real interest rates will not return to their level of three decades ago anytime soon,” he said last week. 

“This could be an advantage for fiscal policy, if not driven entirely by lower global growth. Given current inflation targets, however, it will leave the effective lower bound as a recurring challenge for monetary policy. Financial instability will remain a present threat.”

“Our indicators suggest that the long-run nominal neutral rate has remained stable at around 2 percent. However, our estimates suggest that this rate may be starting to increase slowly.”
– Reserve Bank

But his IMF predecessor, distinguished French economist Olivier Blanchard argues higher interest rates will persist for the foreseeable future. “The interest rate which is needed is going to be higher,” he said in public discussion in March. “And the question is, where does this resilience come from? My sense is it’s due to special factors. It’s due to the excess saving, which has been the result of fiscal policy over the last few years.

“Think, for example, about the Chinese: they relied on kids as basically the insurance for old age. I think they now have to rely much more on themselves and therefore saving.”

Former US Treasury Secretary Larry Summers is more forthright: he believes the past two years’ increase in interest rates will be sustained, though not at such high levels as we see today.

The US Federal Reserve has identified its neutral official rate as 0.5 percent – but Summers argued in a speech this year that it may settle about a point higher in the range of 1.5 to 2 per cent. That would flow through into mortgage interest rates, as well as other borrowing. It would also deliver higher returns on savings.

He says the retired population is bigger relative to young workers. “Some of what’s making the neutral rate be higher may be temporary, but there’s no reason to think that all of it is temporary,” he said.

The Fed’s 0.5 percent is the real neutral interest rate. The nominal rate known to US monetary policymakers as the “R-Star” is 2 to 2.5 percent, similar to New Zealand. 

At present many Fed policymakers believe the underlying trends that kept interest rates depressed before the pandemic like weak productivity, an aging population and other demographic forces, as well as entrenched demand for safe assets, will eventually reassert themselves.

The question is the extent to which that view is now changing – and this week’s Bank of Japan conference is expected to help answer that question.

In advice to the New Zealand Reserve Bank’s monetary policy committee in November last year, bank economists said both domestic and international developments influence the neutral interest
rate in a small open economy like New Zealand’s.

Estimates of global neutral interest rates have been declining since the 1980s. They were driven by demographic change, lower productivity growth, and changes in attitudes towards savings and investment – not just consumers, but also businesses and governments.

But domestically, New Zealand’s lower productivity growth (reflecting an increasing proportion of low-productivity industries, and a relatively slow adoption of global technological developments) also affects its neutral interest rate.

“There is always considerable uncertainty about the level of the neutral interest rate. This is because it is a concept that cannot be directly measured and is only imperfectly estimated. Covid-19 and the war in Ukraine have caused large structural shifts in both the global and the New Zealand economy, which further increase uncertainty,” the Reserve Bank advice says.

“Our indicators suggest that the long-run nominal neutral rate has remained stable at around 2 percent. However, our estimates suggest that this rate may be starting to increase slowly.”

Newsroom Pro managing editor Jonathan Milne covers business, politics and the economy.

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