By Rodney Dickens
[This analysis continues Rodney Dickens' series on what he sees is wrong with the current policy approach of the RBNZ. For links to the previous analysis, see here and here.]
The neutral level of the OCR is the level that is consistent with keeping annual CPI inflation within the 1-3% target range on average over the medium term consistent with clause 2 (b) of the Policy Targets Agreement.
An assessment of a number of the factors relevant to determining the neutral level of the OCR leads to the conclusion that the neutral level may be a bit above the current setting of the OCR at 2.5%.
But if the financial crisis remains elevated the neutral OCR could be as low as 2.5%.
And there is the risk that the latest international turmoil could be a dress rehearsal for a more significant shock, which means an OCR of below 2.5% could end up being justified.
The factors considered in the assessment of the neutral level of the OCR and whether the current rate should be a bit above or below the neutral rate are:
• The impact of the international financial crisis.
• How borrowers are responding to the current level of interest rates.
• Economic growth performance and prospects in light of the impact of the non-interest rate drivers.
• Whether there is any spare capacity in the economy.
• Whether a warning shot needs to be sent across the government’s bow.
The continued fallout from the international financial crisis means the neutral level of the OCR is well below the 5.5% historical average level of the OCR since its inception in March 1999.
It is hard to quantify exactly how much below 5.5% the neutral rate is currently based just on the direct impact of the crisis on the interest rates faced by borrowers. But the crisis means a much lower neutral rate than 5.5%, while there seems no basis for expecting an early, significant resolution of the crisis and there is the risk that the international financial situation will deteriorate further.
The response by borrowers to the current level of interest rates suggests that the neutral level of the OCR could be below 2.5%.
However, as especially mortgage borrowers work off some of the excessive debt accumulated during the speculative bubble in the housing and section markets borrowers may respond more favourably to the current level of interest rates.
After taking into account the impact of drivers of economic growth other than interest rates, the recent below average performance of economic growth can be explained.
This means that from the perspective of the performance of economic growth the neutral level of the OCR is probably not below 2.5% while it might be slightly higher than 2.5%.
Economic forecasts provide an unreliable basis for assessing whether economic growth will end up above or below the sustainable rate of around 2.5% if the OCR remains at 2.5%. But based on the current states of, and likely near term prospects for the main drivers of economic growth the outlook for underlying economic growth, which is growth excluding the impact of the rebuilding in Canterbury, is not likely to be materially different from the 1.5% performance over the last year.
Of particular concern is the risk of a significant deterioration in the international trade cycle.
The existence of a modest amount of spare capacity in the economy means a case can be made for the OCR being marginally below the neutral level for a brief period.
However, the most important measure of underlying inflation is already sufficiently high to mean an OCR below 2.5% cannot be justified currently unless international financial developments result in a further fall in the neutral rate.
When the reconstruction work in Canterbury eventually gets underway in earnest it will provide a significant but transitory boost to economic growth and some boost to inflation.
The focus of monetary policy should be on underlying economic growth excluding the boost from the reconstruction work.
To hike the OCR more than a touch in response to the rebuilding post a major and tragic natural disaster makes no more sense than does cutting the OCR once the rebuilding work eventually tails off.
To do so would only create unnecessary volatility in economic activity and especially housing related activity outside of Canterbury.
Despite 2011 being an election year the government is running what appears to be a sound fiscal policy with a focus on reducing the fiscal deficit.
A case does not exist for increasing the OCR to provide a warning signal to the government.
2. Assessing the neutral level of the OCR
[This section and analysis is in the attached download.]
3. Restating the case for a more stable OCR
[This section and analysis is in the attached download.]
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* Rodney Dickens is the Managing Director Strategic Risk Analysis. See more detail here.