Why the RBA and interest rates are spinning the wheels in neutral

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Great work from Bill Evans at Westpac to round out a pretty bizarre week:

We have recently read with interest a number of pieces from FOMC officials including Chairman Powell and Governor Brainard around the concept of neutral rates.

Neutral rates are “the ideal” for central banks. At that neutral level inflation is stable around its target; there is full employment; and output growth sits at potential. The art of central banking is, at the appropriate time, to move policy towards neutral and to maintain that neutral policy stance.

The FOMC has introduced the concept “short-run neutral” that does not stay fixed but fluctuates with economic conditions.

Initially, when the US economy was labouring under the headwinds of the aftermath of the GFC (including the impact of fear and uncertainty) Chair Yellen assessed that “short run” neutral was lower than equilibrium “neutral”.

Now as time has dimmed the fear factor and the US economy is benefitting from the tailwinds of the tax cuts and the fiscal stimulus, short run neutral is assessed as being higher than the equilibrium neutral.

The FOMC provides estimates of the equilibrium neutral rate in the 2.5%- 3.5% range with the median being just below 3%.

It is widely accepted that the equilibrium neutral has fallen from earlier decades when it was estimated at 4% to 5% for the US. Explanations for this fall are inconclusive although my prior would relate it to higher leverage particularly in the household sector; structural changes in global labour markets which have flattened the Phillips curve; and a long sustained fall in inflation (partly related to the aftermath of the GFC) which structurally lowered long-run inflationary expectations.

Consistent with the assumption that the short term “neutral” is higher than the equilibrium neutral is that the FOMC’s median estimate of the near term peak in the federal funds rate which is higher (3.375%) than the median estimate of the equilibrium neutral rate.

On this basis the FOMC has a clear task. US growth is now clearly above potential; the unemployment rate has dropped to decade lows (and wage pressures are emerging to signal that full employment has been reached); and the inflation rate is near the target level.

It seems safe to conclude, therefore, that the current federal funds rate is below both short term and equilibrium neutral. However, we cannot be certain of the exact level of short term or equilibrium neutral policy, and so the FOMC is well advised to move gradually to avoid pushing policy too far above neutral.

On the other hand the RBA’s task is more challenging. I would argue that the RBA further complicates its task by including an additional component to its “neutral” concept.

Recall the Governor’s comment in June at the ECB Sintra conference: “To try to get [inflation] back to 2.5 very quickly, it would be mainly through people borrowing more money, and having higher asset prices – I think that’s a much bigger risk to our economy than people having surprisingly low inflation expectations.”

For the RBA, neutral might be defined as the level of the nominal cash rate where the economy is growing around potential (generally assessed as 2.75% – 1.75% for the growth rate in the labour force and 1% growth in productivity); inflation is around the target level of 2.5%; the economy is operating at full employment; and, in addition, household leverage is stable.

I expect that the final condition of stable household leverage is an important condition for the RBA to feel that it has achieved its equilibrium neutral interest rate.

With an additional component to the definition of neutral, the RBA, through the regulator APRA, has adopted an additional tool – macroprudential policy which aims to tighten the housing lending guidelines of the major Australian banks.

That policy has been successfully applied and has slowed household credit growth and is stabilising household leverage.

But the side effects of the policy – falling house prices; a downturn in housing construction activity; and a likely negative wealth effect which will spill over to consumer spending – has lowered the short term neutral interest rate.

Other factors that might be lowering the short term neutral rate would be associated with current developments in the global economy around trade policy; financial market volatility; the structural deleveraging which is occurring in China and political uncertainty associated with the imminent Federal election.

On the other hand, the welcome fall in the AUD, which is now down 5% on a TWI basis since the beginning of the year, would be boosting the short term neutral level of rates.

Another challenge with the “neutral” guideline is that the measure of “full employment” is uncertain. Full employment is that level of unemployment below which real wage pressures build. Historically, for Australia, that level has been estimated as 5% but developments in other countries, including the US; UK and Japan indicate that the level of full employment, like equilibrium neutral, has fallen (and partially for similar reasons).

Low wages growth has been partly explained by globalisation; technology; job insecurity; risk aversion and low inflationary expectations. Some of these factors – insecurity; and risk aversion – are more common to Australia while the others are relevant for most labour markets.

Australia’s Employment Report for September, which was released on October 18 printed an unemployment rate of 5% – the “old” measure of full employment but as we saw for the US where the “old “ measure was 4.75% (unemployment rate now printing at 3.7%) it is likely that the unemployment rate will need to fall substantially further before wage pressures signal that full employment has been reached in Australia.

If we consider the “score card” for Australia: GDP growth is certainly above trend in 2018 and the RBA forecasts that it will remain above trend (at 3.25%) through 2019.

Headline inflation has been below 2% (on a calendar year basis) since 2014 and is only forecast to edge slightly above 2% in 2019; the unemployment rate is still above full employment (although we are unsure how far above); and household leverage has stabilised.

The RBA expects that the next move in rates will be up; indicating that it believes that short term neutral is above the current setting. But, arguably, with the gap between short term neutral and current setting narrowing as short term neutral falls, inflation remains stubbornly below 2% and, despite a welcome fall in the unemployment rate, no evidence of wage pressures means this “gap” may be small, signalling caution.

Indeed we would argue that the gap is likely to narrow further making it even more difficult for the RBA to feel confident that the current cash rate is below the short term neutral level.

Clearly, wages growth plays the central role in resolving these uncertainties. A solid lift in incomes would signal full employment is reached; leverage would stabilise even with a modest lift in lending; and inflation pressures might emerge.

The RBA has been “patient” keeping rates on hold since August 2016. That is indicative that it is also not certain where policy stands relative to short term neutral. With, in our view, the gap between short term neutral and current rates actually shrinking a clear signal for the RBA to move seems quite remote.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.