History points to the risk of tight monetary policy
Past rate hike cycles have seen tight monetary policy to control inflation.
One way central banks judge whether they have done enough on monetary policy to return inflation to target is to compare the current policy rate with the neutral policy rate.
The neutral policy rate can be thought of as the interest rate that would prevail if underlying inflation was in line with the central bank's target, output was in line with its potential, and there was full employment in the labour market.
Faced with high inflation, central banks need tight monetary policy, with a policy rate higher than the neutral rate required to slow the economy and bring prices under control.
Unfortunately the neutral policy rate is unobservable and has to be estimated by relying on techniques that extract the neutral rate from market pricing, economic models and/or surveys.
The RBA calculates the neutral cash rate by taking the average of estimates derived from nine different methods, which allows the neutral rate to vary over time.
As at early last year, the RBA put the neutral cash rate at about 1% in real terms, which, allowing for the 2½% midpoint of the inflation target, translated to a 3½% nominal neutral cash rate.
Sidestepping the replication of the nine methods that underpin the RBA's calculations, the average neutral cash rate can be approximated in a timely way by using a simple model based on real bond yields.
This simple model suggests that the neutral real rate picked up further around the middle of last year and currently stands at about 1¼%, which implies a 3¾% nominal neutral cash rate, again allowing for the 2½% midpoint of the target band.
Encouragingly, this lines up with Freedom of Information documents that show that the RBA recently raised its estimate of the neutral nominal cash rate from 3.5% to 3.8%.
Mindful that there is significant uncertainty around any estimate of the neutral rate, this suggests that monetary policy is finally slightly tight (assuming that inflation expectations remain anchored by the inflation target), with the current cash rate of 4.1% slightly above the neutral nominal cash rate of 3.8%.
However, history shows that the RBA has needed to have tight monetary policy in order to contain inflation, which points to upside risks to the current cash rate.
That is, monetary policy has been much more restrictive during past tightening cycles, with a 2pp median of the peak in the cash rate relative to the neutral rate in the five hiking cycles since the late 1980s.
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy, contributing to the investment decisions of the firm. Kieran has long experience as a macroeconomist in both the private and public sectors. He has worked most recently as Chief Markets Economist for National Australia Bank and was previously Chief Economist, Australia and New Zealand, for Barclays Bank and ABN Amro Bank/RBS. Kieran also worked as Principal Adviser on the macroeconomy and budget policy in the Commonwealth Treasury and Director of Forecasting.
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...
Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...
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