MNI: RBA Says Neutral Rate A 'Polestar,' Not A Destination

The Reserve Bank of Australia's estimate of its nominal neutral rate is "not necessarily" a prescription for what policy should do, said Assistant Governor (Economic) Luci Ellis.

“Don’t think of this as a mechanistic approach of ‘we have to get back to neutral’, or above neutral,” Ellis said. “The neutral rate is an important guide rail for thinking about the effect policy might be having. It is not necessarily a prescription for what policy should do.”

The comments in a speech came after the Bank hiked a smaller-than-expected 25bp to 2.6% at its Oct 4 meeting, a move that placed monetary slightly above the Bank's estimated neutral rate of 2.5%. (See MNI STATE OF PLAY: RBA Taps Brakes, Sees Slower Pace Of Hikes)

Ellis sought to push back against some observers who have concluded real rates are too low based on current elevated levels of inflation. The RBA bases its view of the long-term neutral rate on its 2-3% inflation target,

"Given the difficulties and judgements involved in choosing a forward-looking inflation rate, people sometimes resort to using recent observed inflation instead. That’s understandable. Most of the time, when inflation is stable, it won’t put you too far wrong. Conceptually it isn’t quite right, though."

She said the neutral real rate should 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 2.5%”

The RBA uses nine different models to estimate the neutral real rate. The simple average across the nine models delivers a range of outcomes from -0.5% to 2%, with a model average of just under 1%.

Ellis said low neutral rates in a low inflation world would mean central banks would be more frequently constrained by the effective lower bound on nominal interest rates.

However, she also warned that a further increase in the neutral rate would also have implication for balance sheets. She warned that if average real rates rise again then “some deleveraging would be needed.” She said the “process is unlikely to be painless”.

She noted that Australian banks assess loans applications assuming interest rates higher than the prevailing rates. “It is easy to see that these buffers also provide some margin to cushion the adjustment if average real rates were to increase in the future.”