John McDermott: Shifting gear - why have neutral interest rates fallen?
Speech by Dr John McDermott, Assistant Governor and Head of Economics of the Reserve
Bank of New Zealand, to the New Zealand Institute of Chartered Accountants CFO and
Financial Controllers Special Interest Group, Auckland, 2 October 2013.
* * *
"....most usefully thought of as a concept rather than as a number, as a way of thinking about monetary policy
rather than as the basis for a mechanical rule" (Blinder, 1998).1
1. Introduction
I want to thank NZICA for providing me with this occasion to speak about neutral interest
rates, why they appear to have "shifted gear" in the last few years, and what that might
mean. Neutral interest rates are important to the way the Reserve Bank thinks about
monetary policy - especially how stimulatory or contractionary interest rates are - and I want
to share some insights from research my colleagues have been undertaking on this topic.
First, let me recap the reasons behind our most recent monetary policy decision when we left
the Official Cash Rate (OCR) unchanged at 2.5 percent. Looking ahead, we expect demand
in the economy will be boosted by further reconstruction in Canterbury, high export
commodity prices, momentum in the housing market and low interest rates. This pick-up in
demand will be partly offset by fiscal consolidation and continued strength in the
New Zealand dollar, and the starting point is one of very low core inflation. Reflecting the
balance of these forces, the Reserve Bank believes that interest rate settings should remain
stimulatory for some time yet and we noted in our September Monetary Policy Statement that
we expect to keep the OCR unchanged in 2013.
Interest rates, whether we look at the policy rate that the Reserve Bank sets or at the interest
rates that households and businesses face, have been very low for the last four years, and it
seems difficult to imagine that rates can stay at such low levels. We believe 90-day rates
have been stimulatory since early 2009, when the OCR was first lowered to 2.5 percent in
the wake of the global financial crisis (GFC). Indeed, we noted in the September Monetary
Policy Statement
that while we expect to keep the OCR unchanged in 2013, we do expect to
increase the OCR next year. What average might we expect interest rates to head towards
when we do eventually start to increase the OCR, and when would we expect to reach that
level?
Part of answering that question requires taking a position on just how much stimulus current
interest rate settings are adding to the economy. If our economy were growing at a rate with
no under- or over-utilised resources in aggregate (often referred to as a zero output gap) and
inflation were close to the midpoint of our 1 to 3 percent target band, then interest rates that
neither stimulated nor restricted the economy would be appropriate. Such a level of interest
rates can be termed the neutral interest rate. Interest rates set below this "neutral" level tend
to boost the pace of activity and inflation in a sluggish economy where inflation would
otherwise be falling, and interest rates above this "neutral" level tend to slow the pace of
activity and inflation where inflation would otherwise be rising during economic upswings.
Our latest forecasts project the output gap to be near zero and inflation to be close to the
2 percent midpoint in March 2016 (figure 1). Consequently, the appropriate monetary policy
setting at that time should be very close to neutral. Our projections suggest the level of the
nominal 90-day interest rate that achieves this is about 41⁄2 percent.2 This is very close to my
best estimate of the neutral nominal 90-day rate at present, though any point estimate of
neutral comes from a fairly wide confidence interval - perhaps 100 basis points or more.3
At this point I think it is useful to review the economic factors that determine neutral and
explain how the Reserve Bank estimates it.
Figure 1
A stylised view of monetary policy settings
Source: RBNZ
2. What is a neutral interest rate?
To set the scene, it is worth reflecting on exactly what interest rates are. Interest rates reflect
the price of shifting resources from one period to the next. Over long spans of history,
changes in neutral interest rates have been a significant part of the variation in actual interest
rates (figure 2). For example, the change we can see in real mortgage rates over the past
90 years or so is greater than can be accounted for by business cycle fluctuations and
monetary policy.
Figure 2
Real floating mortgage interest rates over a long horizon*
Source: RBNZ
* Nominal interest rates deflated by CPI inflation
Economic theory tells us that changes in neutral interest rates reflect changes in real
economic factors such as population growth, productivity growth, preferences for savings
and also world conditions.4 So it's private preferences and opportunities that determine
neutral - the neutral rate balances the choices of all participants in the market, on average
over time.
How can savings and investment decisions of New Zealanders affect neutral interest rates?
As a starting point, the interest rate can be thought of as the mechanism which reconciles the
demand for funds (consumption and investment) with the supply of funds (savings). What we
see is, in general, people put somewhat more value on consuming today than deferring
consumption until tomorrow. This means a positive interest rate is required to encourage
people to save today. In that context, the fact that New Zealand interest rates normally tend
to be higher than in some other advanced countries reflects New Zealanders' tendency to
invest more than we save.5
As I have mentioned, interest rates can change over time. If there is a change in preferences
so that people now have a greater desire to save today and consume tomorrow, a lower
interest rate will be required to equate savings and investment. And if at the same time
underlying preferences for investment remain unchanged, then we would generally expect
the neutral interest rate to be lower.
When the Reserve Bank sets the OCR, this affects other interest rates in the economy. We
set the policy rate away from neutral when inflationary pressure is rising or falling, to slow or
accelerate demand growth and so alter inflationary pressure. Interest rates above neutral, for
example, will generally discourage people from investing and consuming and encourage
more saving, leading inflation to slow. So if the policy interest rate is at its neutral level,
monetary policy will be neither expansionary nor contractionary.
For our purposes, then, the neutral interest rate is the rate consistent with inflation being
steady at, or close to, the midpoint of the inflation target band and a zero output gap.6 In the
Reserve Bank's framework we have a view of neutral levels for both the policy interest rate,
represented by the neutral 90-day rate, to which I referred earlier, and the interest rates that
households and businesses pay, which we typically proxy by the neutral floating mortgage
rate.
3. What might have affected neutral interest rates in New Zealand?
As I have noted, when I think about whether neutral interest rates might have changed, the
typical factors I look at are world conditions, domestic productivity growth, population growth,
and preferences for savings and investment. While our research indicates that the main
reason for the apparent fall in neutral interest rates currently looks to be weaker productivity
growth, I will go through each of those factors to illustrate how they matter, and why I think
the others have been less important for the recent change.
a) World conditions
Although there was a fall in gross domestic product (GDP) growth around the world at the
onset of the GFC (figure 3), I do not see the world outlook as having more than a marginal
effect on neutral interest rates in New Zealand. The fall in GDP growth following the crisis is
certainly consistent with the drop in actual long-term interest rates seen throughout the world,
but GDP growth in our major trading partners is expected to return to around its pre-crisis
trend. However, we remain wary about the future growth prospects of our trading partners.
The global economy has seen many adverse shocks in the past few years and many
downside risks remain.
Figure 3
GDP growth in selected trading partner economies
Source: Haver Analytics
Figure 4
Real 10-year government bond rates*
Source: Haver Analytics, Federal Reserve Bank of St Louis FRED
database, Bank of England, RBNZ
* Real rates are nominal rates deflated by one-year-ahead inflation
expectations.
b) Productivity growth
As noted, weaker productivity growth looks likely to be the main explanation for a fall in
New Zealand's neutral rates. In the past few years, productivity growth has fallen in
New Zealand when compared to the two business cycles before the crisis. And this story is
not unique to New Zealand (figure 5).
Why does a fall in productivity growth suggest neutral interest rates have fallen? A sustained
fall in the pace of productivity growth will lower returns to investment, making it less desirable
to invest. If the desire to invest falls and the desire to save remains unchanged, a lower
neutral interest rate will be required reconcile savings and investment plans.
Figure 5
Multifactor productivity growth
c) Population growth
World population growth has been trending downwards since the 1960s. However,
New Zealand population growth has only fallen more recently, and does not appear to be an
important explanation for lower neutral rates in New Zealand (figure 6).
Lower population growth decreases the number of people in the labour force, meaning less
investment is needed to provide the necessary capital stock to employ the average labour
force. As investment falls, a lower neutral interest rate - the one that equalises the supply of
and demand for funds - will be required.
Population growth in New Zealand over the last couple of cycles has tended to fluctuate in a
way that does not match the apparent movements in neutral rates, and the recent fall in
population growth is small by the standards of past movements. At the same time, the
longer-lasting downtrend in world population growth raises interesting questions about the
implications for neutral rates abroad.
Figure 6
Population growth (5 year moving average)
Source: World Bank
d) Preferences for savings
As I have mentioned, if people decide to save more and consume less a lower interest rate
would be required to boost the pace of activity and inflation and reconcile saving and
investment plans. But while savings rates have changed since the crisis in New Zealand, this
appears to be more for cyclical reasons than because of a change in underlying behaviour.
For that reason I would not expect it to explain much if any of the fall in neutral interest rates.
After the crisis hit, businesses and households became more cautious leading to a rise in the
household savings rates (figure 7), with the household sector trying to reduce debt and
exposure to financial risk.7
Figure 7
New Zealand savings rate by sector (share of
Gross National Income)
Source: Statistics NZ
During the aftermath of the crisis, the Reserve Bank recognised that it was difficult to assess
how long-lasting household caution would be, with the possibility that behaviour could either
be simply a typical cyclical response to a period of economic weakness, or the early stages
of a more structural change in New Zealander's attitude to debt. As such, we were restrained
in how we changed our view of neutral interest rates (see section 4).
Household savings rates have continued to rise. But national savings has flattened more
recently, driven by the sharp fall in the government savings rate (figure 8). Given that
national savings are what matters in identifying whether neutral interest rates have fallen,
preferences for savings can be only a small part of any recent change in neutral interest
rates.
Figure 8
Government OBEGAL (operating balance before
gains and losses)
To re-cap, of the four factors I have considered today the most likely to explain a fall in
neutral interest rates in New Zealand is the fall in productivity growth. World conditions,
domestic population growth and changes in preferences for savings have probably not
changed enough to influence New Zealand neutral interest rates materially even if they have
generally moved in the right direction. That said, these other drivers do have the potential to
affect neutral rates in the future if recent movements are in fact the beginning of
longerlasting structural changes. These factors have certainly been evident in the general
downward drift of neutral interest rates internationally.
4. How has the Reserve Bank changed its view of neutral interest rates?
Figure 1 showed how we at the Reserve Bank stepped down our view of the neutral 90-day
rate over 2008 to 2010. Although we altered our neutral policy rate assumption, we made no
change to our assumption about the neutral interest rate faced by households and
businesses. We assumed that the increase in the spread between retail rates, such as the
floating mortgage rate, and the policy rate was a result of the premium banks have had to
pay on longer-term funding, with institutional savers being more wary about the risk of term
investments than they were previously. Consequently, borrowing costs are higher for
households and firms, relative to the 90-day interest rate, than in the previous business cycle
(figure 9).
Figure 9
Spreads between nominal floating mortgage rates
and 90-day rates
Source: Haver Analytics, RBNZ
But as I have discussed, we now have more information on the underlying trends that
determine neutral interest rates for households and businesses both in New Zealand and
overseas. The evidence is pointing more and more to lower neutral interest rates. As a result
we have now adjusted our view of the neutral rate for households and businesses, as
proxied by floating mortgage rates, downwards. This view was fully factored into the
September Monetary Policy Statement. Of course, because spreads remain higher than
before the crisis, we have reduced the neutral floating mortgage rate by less than we
adjusted the neutral 90-day rate down.
5. Measurement of neutral interest rates
We have seen these changes in the real economy, but how in practice do we estimate the
level of the neutral interest rate? Neutral interest rates are not observable in the way that the
90-day rate or retail interest rates are. Instead, neutral has to be inferred from the economic
information that we have available. Neutral can also change over time, and it may not always
be clear whether the change is caused by cyclical movements or an underlying trend in real
economic conditions.
One way to estimate neutral interest rates is to use time series econometrics to extract
trends in interest rates over time, and to look at these in the context of behaviour of the
drivers of neutral rates discussed above. The Reserve Bank's estimates of trends in real
long-term interest rates do suggest the neutral real 90-day interest rate has fallen since the
GFC, both in New Zealand and in other countries (figure 10).8 And estimates based on
equations that describe how monetary policy has responded to inflation and demand
pressure in the past also suggest the neutral 90-day rate might be lower since the crisis.9 As
I have discussed, adjustments in the Reserve Bank's forecasting framework between 2008
and 2010 incorporated much of this fall. During this time, the neutral 90-day rate assumption
in our models was lowered by 150 basis points. Because of the rise in spreads of floating
mortgage rates over the 90-day rate we have not reduced our assumption of neutral interest
rates for households and businesses by as much.
Figure 10
Trend in New Zealand real 10-year
government bond rates*
Source: RBNZ
* The real rate is a nominal 10-year rate deflated by one-year-ahead CPI
inflation expectations.
Econometric techniques will always involve some estimation error. To give an idea about the
wide confidence intervals around neutral estimates, between 2000 and 2008 the Reserve
Bank's published research has offered estimates of between 3 and 6 percent for neutral real
90-day interest rates since the early 1990s (Chetwin and Wood, 2013, forthcoming, reviews
these estimates).
However, we have processes for assessing and forecasting economic conditions that
manage this uncertainty. As I talked about earlier this year, we draw on a wide range of
information such as official data, surveys, visits to businesses and labour organisations,
external agencies and external monetary policy advisors to form a coherent picture of
international and domestic conditions and a macroeconomic projection.10 This information
captures our view of the most likely future developments in inflation, output, employment,
interest rates, the exchange rate and other key macroeconomic variables. We also forecast
often - every 6 weeks - which ensures we update and correct our view of real economic
conditions regularly.
Despite all the sophisticated work my colleagues have done to estimate neutral, uncertainty
can never be removed and there remains the chance that neutral may have fallen even
further than we currently assume. This could be consistent with the weaker than expected
inflation seen over the past year or so.11 But this low inflation could also be due to one-off
factors such as telecommunication prices or driven by the high New Zealand dollar. This is
why the Reserve Bank continues to watch developments very carefully. Indeed, there is
some clear evidence that current interest rates are quite stimulatory to some types of activity
- look at the Auckland housing market.
There are many other factors that complicate the measurement of neutral interest rates in
addition to future developments in the real economy. These include the needs to derive real
rates from nominal rates and account for risk premiums. In practice, the Reserve Bank needs
an estimate of the real neutral interest rate. To do this we require estimates of inflation
expectations which are also unobservable and so must be proxied by surveys or different
measures of trends in actual inflation.
We have also seen changes in risk behaviour since the GFC, which has affected risk premia.
Although changes in financial market sentiment need to be considered when making
monetary policy decisions, the high frequency of changes in sentiment in financial markets
offers little insight into whether neutral has changed or not.
6. Conclusion
Having a view on the neutral interest rate helps the Reserve Bank in reaching a view about
where actual interest rates need to be set. We constantly use a wide range of tools
- economic theory, data and econometric methods - to examine whether neutral might be
changing so we have the most up-to-date view on the economy possible. Nevertheless,
because neutral is unobservable and estimates are uncertain, this process cannot be made
into a simple mechanical exercise. Judgement will always be needed - indeed the same kind
of judgement as is needed when making any economic forecast - when forming a view of the
neutral interest rate.
What I have talked about today highlights that over time, there can be changes in the level at
which interest rates switch between being stimulatory and contractionary. Lower neutral
interest rates are not necessarily a good or bad thing; it depends on the reasons for the fall.
For example, if interest rates fall because of falls in productivity growth, that generally would
not be seen as desirable.
The evidence and research we have accumulated does point to neutral interest rates being
lower than in previous cycles. The neutral level of nominal 90-day rates looks to have fallen
to around 41⁄2 percent, though there is a confidence band around that figure. Based on the
uncertainty we've typically found in the past, the band might be in the order of 1⁄2 percentage
point each side of the central estimate. We have lowered the view of neutral 90-day rates in
our forecasting framework in line with that (figure 1). That estimate compares with figures in
2003 of somewhere between 51⁄2 and 61⁄4 percent.
At the same time, we have reduced our view on the neutral lending rate for households and
businesses by less only about 1 percentage point. That is less than the drop in neutral
90-day rates because of the significant increase in the spread between the two since the
GFC.
An implication of a lower neutral interest rate is that households and businesses will face
lower interest rates "on average", but this should not be read as a promise of lower interest
rates all the time. Interest rates will need to be adjusted in response to the state of the
economy. For times when demand in the economy is expanding more rapidly than the
economy's ability to meet that demand interest rates will need to be above neutral. Moreover,
there is no reason to suppose how far interest rates move from trough to peak will be any
different in the next business cycle than they moved in previous cycles.