Jessica Irvine| Sydney Morning Herald| 14 October 2017
What is the right level for interest rates?
It’s hard to think of a more important question for the economy.
Households want to know how much they can borrow and service. Banks want to know how much they can lend to people.
Policy makers, particularly the Reserve Bank, want to know if they’ve got the macro-economic settings right to support a growing economy.
But arriving at the answer to this question is no simple matter.
With interest rates at record lows, it’s something the Reserve Bank has been devoting a lot of time to thinking about.
Of course, it’s the job of the independent central bank to manage demand in the economy, via the manipulation of interest rates, to ensure the economy is on track to meet its objectives of full employment and price stability.
The bank’s mandate has found expression in the goal of containing rises in consumer prices to between 2 and 3 per cent a year.
It’s a delicate balancing act.
If interest rates are kept too low for too long, growth and employment accelerates and you soon risk wages and prices breaking out.
If interest rates are kept too high for too long, it hurts growth and jobs, risking too much price deceleration.
Somewhere in the middle, at any point in time, is the neutral interest rate. This is the interest rate required to bring about full employment and stable inflation over the medium run.
This concept of a “neutral” interest rate is crucial for monetary policy.
Interestingly, exactly where this middle ground lies – the neutral interest rate – can vary over time, depending on a range of factors.
Knowing what it is at any point in time allows policy makers to assess the current “stance of monetary policy”. If interest rates are below the neutral rate, the stance of monetary policy is expansionary. If interest rates are above neutral, the stance is contractionary.
Another way to think of the neutral rate is where, if you believe the Reserve is doing its job correctly over the business cycle, it’s prudent to assume interest rates will return to.
Analysts at the RBA make regular estimates of the neutral interest rate and to feed this information into the monthly decision-making of the bank’s board.
The process was outlined in a recent article by Rachel McCririck and Daniel Rees from the bank’s economic analysis department.
Basically, it involves building a complex model of the economy and feeding in information about economic growth, potential growth, the jobless rate, full employment and inflation.
Each step involves making assumptions and is invariably imperfect, but does provide a good guide to where the neutral rate has been heading in recent years.
Bottom line is, according to most indicators, this neutral interest rate is much lower than it used to be.
From the early 1990s recession and right up to the global financial crisis, the neutral interest rate was remarkably stable at about 3.5 per cent. Add in inflation of 2.5 per cent and you get a neutral RBA cash rate of about 6 per cent.
Add on top of that a lending margin of about 1.5 per cent and it was possible to conclude that the neutral rate of interest rates that mortgage borrowers could expect to pay when the Reserve was not attempting to influence the economy was about 7.5 per cent.
So what about now?
According to the Reserve’s latest estimates, the neutral interest rate today has fallen markedly to about 1 per cent. Add in inflation of 2.5 per cent and you get a neutral cash rate of 3.5 per cent.
So, with today’s official cash rate at 1.5 per cent, clearly monetary policy is highly stimulatory.
At some point, as the economy continues to turn up, that stimulus will need to be removed and policy returned to a more neutral level.
On these estimates, that implies the official cash rate needs to rise 2 percentage points to get to its neutral level.
What would that mean for mortgage rates? That depends on the margin that banks apply on top of the official cash rate. Since the GFC, the average spread to the cash rate applied on housing loans has jumped from 1.5 per cent to 3 per cent.
So borrowers could expect to see mortgage rates of about 6.5 per cent when the the Reserve Bank moves policy to neutral. That’s only about 1 percentage point lower than pre-GFC average, with the impact of higher lending margins offsetting the steeper fall in the neutral interest rate.
Why has the neutral interest rate fallen so much?
Global factors play a role, but the two main reasons in Australia are a lower potential rate of economic growth and higher risk-aversion by households and firms since the GFC.
An ageing population and a lack of mircroeconomic reform means we’re just not expected to grow as fast as we used to, meaning interest rates don’t need to be set as high to guard against run away inflation.
And if businesses remain risk-averse, interest rates will need to be a bit lower than otherwise to encourage investment.
All this means that when the Reserve Bank eventually decides it is done providing so much stimulus to a recovering economy, and it’s time to shift into neutral again, there will be less work to do than previously.
So you can bet that interest rate rises are coming. But you can also bet that they won’t be as steep.