AMW: What does neutral monetary policy look like today?

Now that the other side of the pandemic is emerging, clients are starting to ask how high rates will go when central banks start to normalise policy.

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  • Now that the other side of the pandemic is emerging, clients are starting to ask us how high rates will go when central banks start to normalise policy. This is not a straightforward question and one where NAB is still developing its views.
  • One way to think about how high rates will go is by looking at estimates of the neutral rate of interest – that is the level of the real short-term interest rate that is consistent with activity at potential and stable inflation. Of course, rates may have to go higher than that level should inflation rise above target and monetary policy turn contractionary.
  • To calculate the real short-term interest rate, we use the Holston-Laubach-William methodology which is cited widely in the literature. We then compare Australia’s neutral rate estimate to that of other countries and how it has moved over recent years.
  • We estimate under this methodology that Australia’s real neutral rate is around 0.80%, which is close to the estimate for the US at 0.41% and the Euro Area at 0.48%. Interestingly, Australia’s estimate is below that of the UK at 1.40% and Canada at 1.46%. It is also worth noting Australia’s neutral rate estimate has trended lower post the GFC and post-mining boom alongside a prolonged period of inflation being below target.
  • Adding on the respective inflation targets for each country implies the nominal neutral rate in Australia is around 3¼%, for the US and Euro Area it is around 2½%, while in the UK and Canada it is around 3½%. How does this compare to market pricing? One proxy is to use the 5Y1Y OIS equivalent swaps. On that basis pricing in the US points to monetary policy moving close to neutral in 5 years, but the story is vastly different in Australia, Canada, the UK, and the Euro Area where OIS swaps are well below the estimates.
  • Does estimating long-run neutral rate answer the question of how high rates may go? In short, not entirely. As RBA Governor Lowe noted just prior to the pandemic, neutral rates have shifted lower and the RBA’s policy easing just prior to the pandemic was in part a recognition that neutral rates had shifted lower after the GFC. It is entirely possible that Australia’s neutral rate has shifted lower over the pandemic due to higher precautionary savings or other factors.

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