There has been plenty of discussion about the neutral cash rate in recent months, but a lot of the talk has generated more heat than light. Yesterday, Reserve Bank governor Philip Lowe put the RBA’s position.
Speaking at the Australian Strategic Business Forum, Lowe said the concept of the neutral real interest rate, one that is neither stimulatory nor contractionary, is a useful one in monetary policy determinations.
“From a practical perspective, though, one of the challenges that we face is that the neutral real interest rate cannot be observed or measured directly. It must be estimated or inferred from other information. The staff at the RBA use a wide range of models and techniques to do this,” Lowe said.
Estimates change over time as more information becomes available. This means that there is considerable uncertainty around any particular estimate of the neutral real rate.
“Having said that, most approaches suggest that the neutral real rate for Australia is at least positive,” he said.
A related challenge is that the RBA board needs to translate any estimate of the neutral real rate into an estimate of the neutral nominal rate, as the board sets the nominal cash rate, not the real cash rate.
“This translation requires an estimate of expected inflation. If we take the 2.5 per cent midpoint of the inflation target as a reasonable estimate of medium-term inflation expectations, this suggests that the neutral nominal rate is at least 2.5 per cent,” Lowe said.
“It would be higher than this if medium-term inflation expectations were to shift higher.”
He emphasised that the neutral rate is just one reference point for the board. It is not the basis of a mechanical rule and the board is not on a pre-set path to achieve any specific level of the cash rate.
The RBA has increased the cash rate by 125 basis points over its past three board meetings, taking the cash rate to 1.35 per cent.
Lowe’s comments point to further cash rate increases of at least 115 bps.