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State of the Nation

Welcome to top economist Cameron Bagrie’s monthly deep dive into the country’s economy.

23 April 2024

Where is neutral? The official cash rate where the Reserve Bank neither has the foot on the accelerator or the brake.

After falling over 2000 to 2020, helping drag actual borrowing rates down too, it’s now starting to rise.

In 1997, the neutral OCR was around six per cent. It’s now estimated to have dropped to around two per cent, helped by incredibly low inflation. I’m of the view the neutral OCR is now around 3.5-four per cent.

The neutral rate is important because it will help define where you can expect interest rates and borrowing costs to be on average, and when the economy is balanced in terms of growth and inflation ... not too hot and not too cold.

The neutral rate is unobservable and can change as structural factors change, including how inflation evolves, the risk premium of any country, investment and savings.

Downward trend

Back in 1997, the RBNZ estimates the long-term real (inflation adjusted) neutral OCR was around four per cent, with a range across various approaches of 3.5-4.5 per cent. Assuming inflation of two per cent, this equates to a six per cent neutral nominal OCR.

The real neutral OCR was estimated to have fallen to 0.2 per cent in 2021, with a range of -0.8 per cent to 1.3 per cent, and a nominal neutral OCR around 2.2 per cent. Interest rates did not need to be as high to keep the economy in balance and inflation in check.

That decline over a 25-year period was material and helped drag borrowing rates down. Contributors included a global savings glut, fiscal consolidation, and lower risk appetite post the global financial crisis.

Back in 1997, a nominal OCR of four per cent was consistent with the RBNZ having the foot on the accelerator. By 2021, four per cent would be slamming on the brakes.

Turning point?

There are signs the neutral OCR is rising. The average across a suite of approaches according to the RBNZ is now 0.6 per cent, up from 0.2 per cent in the past year.

In nominal terms that means 2.6 per cent, still low, but off lows, and as we saw between 1997 and 2021, the neutral OCR can trend for a long time.

Because inflation, and expectations of inflation, are higher than two per cent at present, the current neutral OCR is closer to four per cent.

Various factors such as global savings and investment patterns, government borrowing, New Zealand’s risk premium and inflation will impact the neutral OCR.

A global productivity boom, driven by AI along with a green energy transition, could see an investment surge, requiring higher interest rates. Ageing populations, rising geopolitical uncertainty and demands to fund healthcare and address inequality are putting pressure on governments’ fiscal positions and interest rates.

Long-term interest rates are starting to include greater risk premia as the world battles geopolitical tension. But morbid growth, weighed down by demographics, could mean the neutral OCR remains low.

Inflation will be key. Is a two per cent inflation target still achievable? The RBNZ has a remit to do so. But when you see price rises for rates, insurance and energy costs at double-digits, or the potential impact of climate change on prices, I wonder if the inflation target will shift to 2.5 or three per cent? I suspect so at some stage.

That would add 50-100 basis points to borrowing costs and the neutral rate.

My view

I believe the neutral OCR is around 3.5 to four per cent. Low inflation and a stable global environment lured commentators into an ultra-low view of the neutral rate or average borrowing rates. Reality is now sinking in with inflation proving tough to contain, and structural factors pointing to interest rates above last decade’s average.

A higher neutral rate means that interest rates will be higher on average in the future than they were over the last decade, although lower than current levels.

When interest rates head lower, the magnitude might not be as much as hoped if the neutral OCR is higher.

Views expressed in this article do not represent financial advice.

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