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Estimates of New Zealand's nominal neutral interest rate

Andre Castaing, Meltem Chadwick, Jaqueson K. Galimberti, Marea Sing and Evelyn Truong

What this paper is about

Andre Castaing gives a summary of his research and key findings.

Kia ora. I'm Andre, a Senior Economic Analyst here at Te Pūtea Matua - The Reserve Bank of New Zealand.

Our research shows that due to high inflation expectations, the Official Cash Rate - or OCR - would need to be about 3.9% to neither tap the brakes nor hit the accelerator on the economy.

As you can see, the OCR is currently 5.5% comfortably tapping the brakes and reducing inflation in New Zealand.

If most New Zealanders felt confident that inflation will stay at the 2% midpoint of our inflation target band, our long term estimate suggests that setting the OCR at 2.5% would keep the economy on an even keel.

With the current economic environment how we treat inflation expectations is key.

Historically, we might want to focus on the medium to long term when considering neutral interest rates.

But with the recent period of high inflation, short term inflation expectations data holds more weight than ever.

While our indicators suggest that the ideal long term rate is about 2.5%, interest rates still need to be substantially higher in the short to medium term to help bring inflation down, back to our 1 to 3% target band.

To learn more about our indicators for the neutral interest rate and how they influence how the Monetary Policy Committee sets the OCR, check out the full research on our website.

Key findings

  • This Bulletin explains how we construct, use, and think about indicators for the neutral interest rate at Te Pūtea Matua - the Reserve Bank of New Zealand.
  • The neutral interest rate is not directly observable, and there are several alternative approaches to inferring the neutral interest rate from observable data. We currently monitor 5 indicators of the neutral rate based on different data sets and assumptions. We take a simple average of these indicators as an input into our forecasting framework. 
  • Conceptually, it is the real neutral interest rate that influences peoples’ savings and investment behaviour. However, because monetary policy is conducted in nominal terms, estimates of the nominal neutral interest rate are necessary for evaluating monetary policy settings. The nominal neutral interest rate depends on real economic factors as well as inflation expectations. 
  • We find it useful to differentiate between the short-term, medium-term, and long-term estimates of the nominal neutral interest rate. This distinction is particularly relevant in periods where inflation expectations differ considerably across different time horizons, as they recently have. This Bulletin builds on our previous publications on the neutral interest rate by providing summary estimates of the nominal neutral interest rate over different time horizons, accounting for differences in shorter and longer-term inflation expectations.

Why we did this research

The neutral interest rate (NIR) is an important concept for understanding the stance of monetary policy. When the policy rate is below the NIR, monetary policy is thought to be expansionary, stimulating the economy by encouraging borrowing, spending, and investment. When the policy rate is above the NIR, monetary policy is considered contractionary, exerting a dampening effect on the economy. Estimates of the NIR inform central bank assessments of the current monetary policy stance, as it serves as a benchmark against which the prevailing policy rate can be compared. 

Generally, the NIR is an interest rate that would be consistent with a stable economy in terms of output growth, credit growth, and inflation, in the absence of economic shocks. More specifically, we define the NIR as the level of the Official Cash Rate that, over time, would be consistent with no over- or under-utilisation of economic resources and stable inflation.

At the Reserve Bank of New Zealand - Te Pūtea Matua, we find it useful to differentiate between the short-term, medium-term, and long-term. Nominal NIR estimates across these different horizons have different interpretations and serve different policy purposes:

  • The short-term nominal NIR consists of the real NIR, plus inflation expectations over the 1 to 2 year horizon. This concept is useful for thinking about whether current OCR settings are contractionary in the current period.
  • The medium-term nominal NIR consists of the real NIR, plus inflation expectations over the 2 to 5-year horizon. This concept is useful for thinking about what level the OCR should tend towards as the output gap closes. However, it is not necessarily the same as the endpoint of the OCR in our published projections, since we do not always assume that all shocks to the economy have died out within the policy projection horizon.
  • The long-term nominal NIR consists of the real NIR, plus inflation expectations over a horizon of 10 years or more. When monetary policy is credible, these inflation expectations will be very close to 2%. An estimate of the long-term NIR is used in our core forecasting and modelling framework, where it is the assumed trend/equilibrium interest rate. Most often, when central banks talk about nominal neutral interest rates, they are talking about the long-term nominal rate.

What data have we used?

The RBNZ suite of NIR estimates is currently composed of 5 key indicators. These indicators are based on different models and data sources. While minor adjustments and recalibrations have been made through time, the models in this suite remain broadly consistent with those outlined in Richardson and Williams (2015).

There are 3 broad categories of indicators in the suite, where each is based on different key assumptions, and has its own relative strengths and weaknesses. Due to these limitations of each individual indicator, we use a broad range of approaches to infer the level of the NIR. 

 

 

Diagram showing the RBNZ neutral suite