New Zealand's neutral interest rate has fallen below 4 per cent and a lower New Zealand dollar would help rebalance growth and lower the nation's net foreign liabilities, said Reserve Bank assistant governor John McDermott in a speech.
The level of the neutral interest rate is one of three key economic trends the Reserve Bank regards as particularly important, along with potential output growth and the equilibrium real exchange rate, said McDermott.
"These trends are the anchors around which we aim to stabilise the economy, and thereby inflation over the medium term. While these trends are unobservable and the Reserve Bank has no control over them, they're important to pin down so that monetary policy can be set appropriately."
McDermott likened them to stars the central bank uses for navigation, noting they are "unobservable and complex to estimate."
He said the central bank's modelling points to a neutral interest rate below 4 per cent, with the median of the indicator suite currently sitting around 3.5 per cent. However, "the estimates in the models from our indicator suite currently range between 2.6 and 4.6 per cent, highlighting the significant uncertainty around our estimate," he said.
"Overall a neutral rate of around 3.5 per cent implies that monetary policy is stimulatory at present, given an official cash rate of 1.75 per cent," said McDermott. However, "we have been factoring in this ongoing decline in the neutral interest rate for some time, so the overall impact on the outlook for interest rates over our projection horizon from this particular update will be modest," he said.
According to McDermott, the neutral interest rate and the economy's potential output are interrelated, with both factors sharing common drivers. Potential output growth in New Zealand is currently estimated to be 2.9 per cent per annum. The current strength of potential output growth has been driven by growth in the labour supply and the capital stock. There has been almost no contribution from productivity growth in recent years, he said. In early 2015, the RBNZ regarded the neutral interest rate as being around 4.5 per cent.
Regarding the real exchange rate, McDermott said the central bank's modelling indicates the current level of the real exchange rate is consistent with the net foreign liabilities remaining at about 60 percent of gross domestic product. "A lower New Zealand dollar would be needed to lower NFL-GDP and our external vulnerabilities further," he said. From a growth point of view, a lower real exchange rate would help rebalance growth towards the tradables sector, especially as not all traded industries are benefiting from the current high terms of trade, said McDermott.
He said another key concept is core inflation "because by filtering out temporary factors it provides a better guide to future medium-term inflation," he said. Core inflation is currently estimated to be 1.4 per cent and has broadly tracked sideways over the past year. "So while inflation pressures have lifted from the lows seen in early 2015, they still appear to be relatively moderate," he added.
The New Zealand dollar was little moved on the speech and Stuart Ive, OMF private client adviser, said that given the long and short of the speech suggested monetary policy was for the RBNZ like tracking stars that are unobservable and complex to estimate "I suggest they get a better telescope."