Interest rate rise could surprise, economist warns

Interest rates could increase at a rate that is much faster than the market expects, NZIER principal economist Aaron Drew is warning.

Thursday, September 24th 2015, 3:07PM

by Susan Edmunds

The Reserve Bank today published a report detailing how it estimates New Zealand's neutral interest rate.

The report, by Rebecca Williams and Adam Richardson, says it is important the Reserve Bank knows what a neutral rate would be, so it can gauge how expansionary or contractionary its current monetary policy settings are for the market.

If it worries that inflation is tracking above its target band of 1% to 3%, it is more likely to raise the OCR above the neutral rate. If inflation is low, it will position the OCR below the neutral rate.

“Such a policy reaction helps keep longer-term inflation expectations anchored close to the target mid-point,” the report says.

The Reserve Bank continually monitors the economy for possible changes in the neutral rate, including assessments of consumer attitudes to debt and risk, the economy's potential growth rate, and international developments.

Williams and Richardson said current assessments suggested the neutral 90-day interest rate sat between 3.8% and 4.9% with a mean of 4.3%. The bank judged the nominal neutral 90-day rate to sit at 4.5%.

The 90-day rate closely follows the OCR.

When the OCR was at 5% in 2008, floating mortgage rates topped 10%.

Drew said the Reserve Bank's assessment was in line with NZIER's.

But he said with the OCR currently so far below what the RBNZ considered the neutral rate, at 2.75%, borrowers should not become complacent.

Drew said there were signs of strength in the economy that the Reserve Bank acknowledged but was not yet acting on, which could drive it to want to bring rates closer to a neutral position.

"We suggest interest rates are going to get back to a neutral position sooner than the market is currently forecasting. If borrowers are thinking low interest rates are forever they might be mistaken. Homeowners or investors who are highly leveraged need to factor in the potential for rates to be much higher than they are."

He said it was possible that interest rates could return to pre-GFC levels, or higher, within two to five years.

Infometrics economist Benje Patterson said the neutral rate was just one of the factors the RBNZ considered in its OCR decisions.

"The Bank has estimated its neutral interest rate of 4.5% in nominal terms, but in reality it targets a real interest rate by subtracting inflation expectations for the next couple of years. With the Reserve Bank required to target 2% inflation, this implies the Bank views neutral real interest rates as sitting at 2.5%. At present, the official cash rate is set at 2.75% and the Bank has forecast that inflation will hit over 2% by early next year meaning that the real implied interest rate from the official cash rate is closer to the 0.5%-0.75% range. At this sort level, monetary policy is very much in expansionary territory and this is needed to support the economy through a period of low dairy prices, el nino risks, and global financial uncertainty."

He said the Bank acknowledged there was some evidence of the neutral interest rate having fallen over recent years.

"This is no surprise given how low target interest rates in developed economies have been kept for such a prolonged period and that expectations of these rates form one of the Bank’s estimation techniques."

Tags: interest rates OCR