The Reserve Bank has been doing some stargazing lately. Not the kind that sit high in the sky but rather the kind that help it determine how tight or how loose monetary policy is. The bank's conclusion from this latest analysis is that the neutral setting of monetary policy has moved down, implying monetary policy, at its current setting, is not as easy as previously thought.
The stars referred to here are u-star, r-star, and y-star. These are the levels of unemployment, interest rates and growth at which inflation is stable and where monetary policy is neutral. In economic models, these variables are often denoted by an asterisk, or star.
Why is it important to know where neutral is?
Knowing where neutral is helps inform central banks about how tight or how loose the current setting of monetary policy is. It is not a forecast of where the bank thinks interest rates, unemployment or growth will go, nor is it a target. Rather, it is an academic construct, a benchmark, against which the setting of monetary policy can be measured.
To be clear, stargazing is not new for the RBA nor does it represent a shift away from its current dual mandate of targeting full employment and inflation at 2-3%. A review of where neutral is in the economy happens regularly as it does within other central banks. In a 2018 speech, US Federal Reserve Chairman Jay Powell compared monetary policymakers to sailors who use the stars to navigate by when plotting a course for the economy.
A regular re-calibration is needed because, just as the stars in the sky move, so does the neutral level of monetary policy. As Powell said in August last year:
“Navigating by the stars can sound straightforward. Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly.”
Failing to re-calibrate where neutral is could lead to policy error. Such was the case in the 1970s when policy in the US was arguably left too loose for too long. Inflation soon erupted into the double-digits.
The same potentially could be said at the turn of this century when the tech bubble burst. Alan Greenspan, then Governor of the Federal Reserve, cut interest rates from 6.5% to 1% and left them there for a year before gradually raising them again. The over-easy stance of monetary policy was the tinder that sparked the housing boom that ultimately led to the financial crisis in 2008.
More recently, the bond market would argue the US central bank tightened policy too much last December, taking the setting inadvertently into restrictive territory. The market is now urging rate cuts.
Such policy error happens because neutral is not directly observable. This is one of the reasons why monetary policy is the primary cause of a recession. Central banks typically tighten policy too much. By the time this is realised, it is invariably too late.
What causes neutral to fall?
The chart below, taken from some earlier work from the RBA (“The neutral interest rate”, September 2017), shows how neutral has fallen across a number of countries around the world. What is particularly noteworthy is the fact that the decline has been most evident since the 2008 financial crisis. Here, the RBA estimates that Australia’s neutral interest rate has fallen by about 170 basis points (1.7 percentage points) since 2007. This lower neutral reflects an economy that is operating at a lower level of efficiency. (Note this chart refers to real interest rates, that is, the cash rate less inflation.)
Chart 1: Global neutral interest rates
Where neutral is can change because of changes in the underlying structure of the economy. An ageing population, slower population growth, weaker business investment, and lower productivity growth are all reasons for why neutral can fall. Except for weaker population growth, all have been features of the Australian economy for the past decade or so. The Productivity Commission's latest examination of the economy reveals that Australia has endured six years of poor productivity growth, driven in large part to a decline in investment since the 2012 mining construction boom.
Chart 2: Australian productivity growth slowing
Last week, the RBA re-calibrated where it sees the neutral unemployment rate given the general absence of wage inflation. The RBA’s analysis, presented in a paper by Deputy Governor Lucy Ellis, concluded that the neutral level of unemployment has declined from around five percent to around four-and-a-half percent now. With the current unemployment rate at 5.2%, this suggests there is still slack in the economy and that monetary policy can be eased further before inflation begins to fire.
Implications for monetary policy
Navigating by the stars is about guiding monetary policy around an assessment of where the neutral level is. If actual growth, interest rates or unemployment in the economy is at its neutral level, then neither inflation nor deflation is evident. The economy is said to be in equilibrium. This then determines the neutral level of monetary policy. Whether monetary policy is considered too tight or too loose depends on where the current level of interest rates stands in relation to the neutral setting.
For the RBA, the implication from its recent stargazing exercise suggests the current setting of monetary policy is not as expansionary as previously thought. This then implies further easing in monetary policy ahead.
Inflation pressure can drop with productivity gains; think technology that reduces wage growth. We can still have economic growth in a low inflation or even deflationary environment. Central banks lower the investment hurdle (interest rates) in this situation at the peril of supporting zombie companies and non-productive investment. Listen to Stan Druckenmiller question the logic of pushing interest rates down the rabbit hole (starts at 16m10 of the video): https://youtu.be/r7kMSqgruOY?t=970