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RBA outlines how it determines elusive ‘neutral’ interest rate

The Reserve Bank of Australia this morning has opened up on how it works out the “neutral” interest rate. It’s effectively the Goldilocks rate that is neither contractionary for the economy nor expansive, Luci Ellis, an assistant governor, says.

But we’re not at the neutral rate just yet. The cash rate is at 2.6% after last week’s surprisingly small rise of 25 basis points rather than the 50 basis points most economists expect.

Investors have been again lifting their expectations of how high the rate will go, and are toying with a 4% rate in about a year’s time.

Anyway, back to that Nirvana of cash rate neutrality – the RBA targets that elusive level over time. Given the expectations of where inflation is going lately, it’s good that they take a long lens.

Ellis says:

Current inflation is very high, and expected to stay high in the short term.

But beyond the next year, inflation expectations remain well anchored inside the target range, both here and overseas.

If that anchor were to loosen, that’s another story.

In recent decades, the neutral rate has been sinking, for some interesting if unclear reasons. One issue, post global financial crisis, is that prospects for global growth over time have dimmed, so businesses saw little incentive to invest in expansion (and bought back their own stock instead).

(If China ends up in a real estate derived funk, there goes the dynamo that kept Australia and much of the world’s economy humming after the GFC.)

Ellis says economic theory tells us the neutral rate is “real” because inflation-adjusted interest rates matter for people’s saving and investment decisions.

People look through the expected inflation component of nominal rates; lenders expect to be compensated for it, and borrowers expect to have to provide that compensation.

Not surprisingly, there is no magic number that tells us what the neutral rate is, or will be, since conditions are always shifting.

So where does it leave us? To the RBA, the neutral rate is just “a pole-star to guide us”.

“[A]s we navigate the narrow path to our intended goal, we welcome any faint light that those stars may cast,” Ellis says.