Level which neither stimulates nor restricts economy lowered to 4.5 per cent

The Reserve Bank has lowered its estimate of the neutral short-term interest rate - which neither stimulates nor restricts the economy - to around 4.5 per cent, from 6 per cent before the global financial crisis.

That is about 2 percentage points higher than where market rates are now and on the bank's forecasts the conditions which would warrant a neutral setting will be reached in early 2016.

Assistant governor John McDermott in a speech to the New Zealand Institute of Chartered Accountants said: "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."

Lower neutral interest rates implied the interest rates faced by household and businesses over the longer haul were likely to be lower than in the past, he said.


The complexities of estimating the neutral rate meant that the 4.5 per cent estimate was give or take half a percentage point. And the bank had lowered its estimate of the neutral rate for lending to households and businesses by less - 1 percentage point - to reflect the wider spread between 90-day wholesale rates and floating mortgage rates which had prevailed since the global financial crisis, McDermott said.

The neutral level of interest rates might have fallen even more than the bank assumed.

"This could be consistent with the weaker than expected inflation seen over the past year or so," he said.

"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."

The fact that New Zealand interest rates tended to be higher than in some advanced countries reflects New Zealanders' tendency to spend more on investment than we save.

Weaker productivity growth over the past few years, compared to the two business cycles before the crisis, was the main driver of the lower neutral rate, McDermott said.

"A sustained fall in the pace of productivity growth will lower returns to investment, making it less desirable to invest," he said.

"If the desire to invest falls and the desire to save remains unchanged, a lower neutral interest rate will be required [to] reconcile savings and investment plans."

Likewise, if people decided 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," McDermott said.

In any case it is national savings and not just household savings which matters when trying to figure out if neutral interest rates have fallen, and the recession and the Christchurch earthquakes have seen a sharp drop in the Government's contribution to the national savings rate.