Tuesday, 29 September 2015

Neutral, or too high?

Last week the Reserve Bank came out with the latest of its Analytical Notes - a series I highly recommend. They're pitched at the intelligent citizen, and they also have a 'non-technical summary' at the front, so even if monetary policy or macroeconomics isn't your go-to choice for a light read, you'll find the material both accessible and interesting.

This latest one is more interesting than most - "Estimating New Zealand’s neutral interest rate", by Adam Richardson and Rebecca Williams. Obviously the Bank needs a view on the neutral rate so as to know whether its setting of the cash rate is on the side of policy stimulus or on the side of policy constraint, but it's also interesting for the rest of us, as it's a pointer to whether borrowing costs are relatively low or relatively high.

Intuitively I think we all know what a 'neutral rate' is, but it's harder to pin down an exact definition. The paper says that the neutral rate is "a level of the nominal 90-day bank bill rate that it [the Bank] believes is neither expansionary nor contractionary" and "the interest rate that would prevail once all business cycle shocks have dissipated and inflation is expected to remain at target". The paper doesn't mention where the exchange rate would be at the time, but I suppose we have to assume that the exchange rate is at some middle-of-the-road, purchasing-power-parity sort of level.

The interest rate that would prevail in 'normal', neither boom nor bust conditions, and that would be consistent with inflation steady and the Bank being able to stand pat, is, as the paper says, not directly observable, as things are never going to stand still long enough for you to measure it. So you've got to sneak up on it, and the authors did so from five separate directions. Unsurprisingly the different perspectives give different answers for the neutral 90 day bank bill rate: the range of answers is shown in the graph below. The average is 4.3%, and the Bank's current operating assumption for its policymaking is there or thereabouts, at 4.5%. The Bank's take on the neutral floating mortgage rate, by the way, is 7%, or the neutral 90 day bill rate plus a 2.5% margin.

It's interesting that four of the five approaches have the neutral rate falling. One approach has it bottoming out around the end of the GFC, in 2009-11, but rising quite strongly since, which seems on the implausible side. The ones that have the neutral rate falling, generally have it falling most during and post the GFC period, which seems reasonable: the world seems to be a different place since in a number of respects (including, for example, wage-setting).

But it may not all be down to the GFC: one of the approaches has the neutral rate falling steadily since around the turn of the millennium, and that also makes some sense to me. You'd expect that the Bank would have garnered some increased policy 'credibility' (as the jargon has it) over that period. People would have come to believe more strongly - the odd misstep apart - that the Bank was on top of its inflation-targetting brief. And as they did, the Bank would have been able to exert more effective pressure with less effort, the proverbial 'bigger bang per buck', which is another way of saying that the neutral rate must have gone down.

If anything, I'd say the Bank's operating assumption of 4.5% is a bit on the high side. For one thing, it would be near the top of that target band in the graph, if you discounted the one approach that has the neutral rate rising (and which is responsible for the 4.8% top of the shaded band). And for another, if I put a fund manager's hat on, I'd say that there ought to be a low, and maybe close to zero, long-term after-tax real return to holding cash. At 2% inflation (middle of the target range) and a 28% corporate tax rate, bills at 4.5% would offer a tax paid nominal return of 3.24% and a real after tax return of 1.22%. Or for holding cash (say 20 basis points below bills) an after tax real return of 1.07%. In current circumstances, that looks a return that's on the high side for a liquid risk-free asset.

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