An article in the Sydney Morning Herald last month looked the Reserve Bank of Australia (RBA) and the neutral interest rate. For almost a year the RBA has kept Australia’s official interest rate at 1.5% and uses this instrument to control the overnight cash rate to try to manage the economic activity of an economy. EG.
Expansionary = Lower interest rates = encourages borrowing and spending
Contractionary = Higher interest rates = slows the economy down with less spending
How do we know that 1.5% is either expansionary or contractionary? Central banks indicate what they believe is the neutral rate of interest – this is a rate which is defined as neither expansionary or contractionary. In Australia the neutral is estimated to have fallen from 5% to 3.5% since the GFC. RBA deputy governor, Dr Guy Debelle, explains that the neutral rate aligns the amount of nation’s saving with the amount of investment, but does so at a level consistent with full employment and stable inflation. In Australia this equates to 5% unemployment and 2-3% inflation.
The level of a country’s neutral interest rate will change with changes in the factors that influence saving and investment.
More saving will tend to lower interest rates
More investment will tend to increase interest rates
Debelle indicates that you can group these factors into 3 main categories:
1.The economy’s ‘potential’ growth rate – the fastest it can grow without impacting inflation.
2. The degree of ‘risk’ felt by households and firms. How confident do they feel about investing. Since the GFC people are more inclined to save.
3. International factors – with the free movement of capital worldwide global interest rates will influence domestic interest rates.
“We don’t have the independence to set the neutral rate, which is significantly influenced by global forces. But we do have independence as to where we set our policy rate relative to the neutral rate.” Dr Guy Debelle