In Search Of OCR's Cruise Control
A neutral official cash rate is where the Reserve Bank neither has the foot on the accelerator or the brake, writes Cameron Bagrie, but finding the right highway can be tricky.
1 March 2023
It is a key number that will help define where borrowing rates reside on average; key numbers for borrowers including investors who are not just interested in current borrowing costs, but where they might sit over a decade.
The neutral OCR is where the Reserve Bank neither has the foot on the accelerator or the brake. It is also unobservable. We do not know what the number is. Think of it as the number we need to keep inflation around 2 per cent on average. We experienced decades of low inflation, so that number was low and falling.
It now looks to be rising, which carries the implication that using recent trends for interest rates might understate where borrowing rates could sit in the future.
The neutral OCR trended south over several decades, according to the Reserve Bank of New Zealand.
Back in 2000, the neutral OCR was estimated to be around 5 per cent. By 2019 it had fallen to 2 per cent. Other countries saw similar shifts. Interest rates did not need to be as high to achieve inflation objectives.
That trend was mirrored in floating and fixed lending rates, which headed down too. A structural shift lower in interest rates was great for property. It lowered borrowing costs. Investors chased yield which drove up asset prices.
There are expectations that while the level of interest rates is a headwind right now, with fixed lending rates exceeding 6 per cent, eventually they will go down as monetary policy returns to a more neutral setting. If the OCR goes back to 2 per cent, then borrowing rates could return towards 4 per cent.
DEMAND AND SUPPLY
In the long run the neutral rate of interest is determined by the supply of and demand for savings. Savings must equal investment. If you have lots of savings and insufficient investment, then interest rates do not need to be as high.
The Reserve Bank also pointed to a range of factors in their November Monetary Policy Statement that can influence demand and supply of savings, including “demographic change, lower productivity growth, and changes in consumers’, businesses’, and governments’ attitudes towards savings and investment”.
Declining inflation expectations over a long period also played a role. A goldilocks world of low and lower inflation meant the actual OCR, and the neutral OCR, did not need to be as high to keep inflation low.
PLACE YOUR BETS
There is one school of thought that says we are set for a sustained period of persistently slower growth over the coming decades, with one contributor being demographics. They point to Japan. That argues for continued low neutral interest rates and actual interest rates returning lower after the war against inflation is won.
Another group points to the global economy’s massive investment needs, across climate change, energy including the transition to clean energy, infrastructure, housing, healthcare and the productivity growth that could come from investing technologies such as artificial intelligence as the fourth industrial revolution takes hold, and we move from the industrial age to the information age.
Sometimes it pays to do a common-sense test. With inflation elevated and well above 2 per cent, it seems inconceivable the neutral OCR in New Zealand or other countries could still be 2 per cent. The real or inflation adjusted OCR would be hugely negative.
A low and falling neutral OCR occurred in an era when central banks struggled to get inflation UP to 2 per cent. We now have a battle on our hands to keep inflation DOWN to 2 per cent.
Falling interest rates, low inflation and diminished volatility made for a great investment climate. We now have the reverse.
ON THE MOVE
The neutral OCR can be expressed in nominal or real (inflation adjusted) terms and expressed in the long run or short run.
They give different answers. According to the RBNZ, long-run estimates using the inflation target of 2 per cent say not much has changed; the neutral OCR is still
2 per cent. Conversely, short-run measures using near-term inflation expectations suggest the neutral OCR is a lot higher than 2 per cent.
A combination of the two (the Reserve Bank call this a forecast horizon neutral OCR) has risen from 2.1 to 2.9 per cent with a confidence bound around those numbers. That is a big shift.
The numbers themselves are largely incidental. The key question for investors is whether they think the old world, and 2 per cent neutral OCR, is still in the ballpark. My suspicion is “no”. Amongst all the economic wizardry to justify lower and low rates, maybe we just got lucky on the inflation front and that defined where the likes of the neutral OCR ended up.
THE BOTTOM LINE
Today’s inflation environment versus the past three decades is like comparing chalk with cheese. We are now stepping back from globalisation, that powerful force that helped keep global inflation low.
Climate change and the wrath of Mother Nature means ongoing supply shocks, which adds to inflation. All power to the employer is now all power to the employee, adding to wages and labour costs. There is huge pressure for governments to spend more and address infrastructure deficits. Baby boomers are now spending, not saving.
Do not be surprised if actual interest rates and neutral interest rates, or where rates sit across the cycle, are higher than what we have seen for the past decade. The same applies to borrowing costs.