Global economy: what is neutral?

The Reserve Bank of Australia (RBA) had markets moving this month, particularly the Australian dollar. It inadvertently did this when it put a number on the neutral rate of interest in Australia (the point at which policy is judged from being expansionary to contractionary, or vice-versa) in its June Board meeting minutes. The number itself was of no surprise to economists, but given the demand from markets for hawkish fodder, as other central banks move to remove policy stimulus, this was interpreted somewhat as a statement of intent. It turned out to be a mis-interpretation as the RBA qualified the discussion as being a theoretical one, with no implications for short-term policy settings.

Nonetheless, it did highlight a narrative that has recently emanated from several global central banks, as they contemplate removing policy accommodation. Indeed, the nominated neutral interest rate is now lower than it was previously and will be so for the foreseeable future. The RBA itself noted in its minutes that its estimate of the neutral rate is around 3½%. The Reserve Bank of New Zealand followed up relatively quickly in a statement supporting this level in its context. The Bank of Canada has been discussing the neutral rate for some time and re-iterated in its July 2017 Monetary Policy Report that “The neutral nominal policy rate in Canada is estimated to be between 2½ and 3½%.” The US Federal Reserve (the Fed) also subscribes to this view in its quarterly longerrun forecasts that, given it assumes the economy will be running at potential over the longer run, can be interpreted this way.

Australia: neutral cash rate
Economic trends and lenders costs push neutral rate lower


Source: IFM Investors, RBA

All central banks have arrived at this approximate estimate from levels that were significantly higher. For example, in the January 2012 minutes of the Federal Open Market Committee (FOMC), it noted that “longer-run nominal levels [of the neutral rate] were in a range from 3¾ to 4½%”. And the RBA itself estimated the neutral rate above 5% in the pre-financial crisis, pre-resources bust period. Nonetheless, all of these estimates from central banks are just that: theoretical estimates. No central bank knows what the neutral interest rate is – not until they reach it. Until then, they will be feeling the way with monetary policy as they remove stimulus. This potentially creates a risk to the economy should they overshoot. That is why we should expect that all central banks will remove current policy accommodation extraordinarily gradually – we are not in a ‘normal’ tightening cycle.