this is because of time preference. people would rather have a dollar now than a dollar tomorrow or next year. they demand some compensation for having to wait, even if the payoff next year is risk - free. because the policy rate represents the risk - free short - term interest rate, it embeds people ’ s underlying time preference. so we should expect the neutral real rate also to be positive, though it could be small. and when you add in the condition that inflation should be at target, it implies a nominal neutral rate in australia of at least 2½ per cent. because the definition of the neutral rate can be framed in different ways, and because of the inherent difficulties in measurement, at the bank we use nine different models to estimate it. these nine models are derived from three broad approaches. for each approach, we construct three models, each with minor variations. approach 1 : the neutral rate is inferred from financial market pricing. it estimates the neutral rate as the average of expected future short - term real interest rates derived from a model of the term structure of nominal and real interest rates, adjusting for term premia. [ 3 ] the underlying assumption is that the real interest rate should revert to its neutral rate over time as the effects of shocks fade. the three models estimated using this approach assume different horizons over which the interest rate settles at neutral – three, five and 10 years. approach 2 : a statistical model is used to infer the neutral rate at each point in time as the level of the real policy rate that would prevail if inflation is at target, output is at potential and the economy is at full employment. [ 4 ] the model updates its estimate of the neutral rate each quarter based on how much some variables deviate from the model ’ s predictions for the previous quarter. this method makes strong, but standard, assumptions about the structure of the economy, including the relationship between output and inflation and the gap between the cash rate and the neutral rate. the three specific models we use allow for varying emphasis on different drivers of inflation – for example, domestic versus global factors. approach 3 : a flexible statistical model is used to forecast the future value of the policy rate once all cyclical influences have dissipated, which is then used as an estimate of the neutral rate. the idea is that this forecast is the trend value to which the policy rate will converge based on structural influences. [ 5 ] in practice, this method makes fewer assumptions about economic structure

using different inflation measures % % model - average * range * * cash rate target * * * inflated using expected inflation. inflated using the inflation target or trimmed mean inflation. source : rba what are the consequences of a low neutral rate? it is not necessarily good or bad for the neutral rate to be at a particular level – it just is what it is. given the possible role of demography and inequality in bringing the neutral rate to low levels, it is plausible that low neutral rates persist for the foreseeable future. if so, there are some implications to consider. a low neutral rate in a low - inflation world means that the economy could be more frequently constrained by the effective lower bound on nominal interest rates. it becomes harder to stimulate the economy when needed. the central bank must resort to other measures beyond reducing the cash rate to support the economy. this is one reason why central banks have inflation targets that are above zero. another implication is that it can make it harder to achieve a desired rate of return. so investors with a mandate to achieve an absolute return could end up taking on risk that they would otherwise not take. alternatively, the neutral rate could increase at some point. this is also plausible : the factors holding back productivity growth could dissipate ; asian governments will not necessarily continue to accumulate foreign reserves at the rate they did in the early 2000s ; and fiscal consolidation might not be as much of a priority as it was in europe in the early 2010s. an increase in the neutral rate has important implications, which will depend crucially on the cause of the increase. for example, those who look forward to a future of faster productivity growth must recognise that this will likely imply higher real rates as well as higher trend growth. this matters for investors, borrowers and fiscal authorities alike. these implications are mostly benign, but not if global productivity growth picks up and australia does not keep pace. a future increase in the neutral rate would also have implications for balance sheets. lower average nominal interest rates mean that you can service more debt for the same repayment. if the reason average nominal rates are lower is a permanent disinflation – as occurred after australia adopted inflation targeting in the 1990s – the resulting expansion in balance sheets is sustainable. but if average ( real ) rates increase again, some deleveraging would be needed. that process is unlikely to be painless. if that were to occur, interest rate buffers become particularly valuable. in australia and some other countries, banks