Central Banks and Neutral Rates

Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.

In most economies post GFC the neutral rate of interest fell as they have required lower rates to try and encourage growth. See table below of current rates of Central Banks and approximate neutral rates.

CB Interest Rate Nov 13

What indicators shoud you look at as to whether neutral interest rates might have changed? Here are 4 that are identified by John McDermott, Assistant Governor of the Reserve Bank of New Zealand:

1. World Conditions

Gowth of the major trading partners of any country can put pressure on aggregate demand which consequently causes inflationary conditions. With this and inflatinary expectations there could be pressure on a central bank to increase interest rates

2. Domestic productivity growth

A continued decrease in productivity growth will lower returns to investment, whcih means that investment is less attractive. If the desire to invest falls and the desire to save remains unchanged, a lower neutral interest rate will be required reconcile savings and investment plans.

3. Population growth

Lower population growth decreases the number of people in the labour force, meaning less investment is needed to provide the necessary capital stock to employ the average labour force. As investment falls, a lower neutral interest rate – the one that equalises the supply of and demand for funds – will be required.

4. Preferences for savings and investment

If people decide 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.

An implication of a lower neutral interest rate is that households and businesses will face lower interest rates ‘on average’, but this should not be read as a promise of lower interest rates all the time. Interest rates will need to be adjusted in response to the state of the economy. For times when demand in the economy is expanding more rapidly than the economy’s ability to meet that demand interest rates will need to be above neutral. Moreover, there is no reason to suppose how far interest rates move from trough to peak will be any different in the next business cycle than they moved in previous cycles. John McDermott, Assistant Governor of the Reserve Bank of New Zealand

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