RBNZ aims for interest rates that are not too high, not too low

One reason the Reserve Bank of New Zealand (RBNZ) felt it could reduce the official cash rate (OCR) earlier this month was because it was higher than the nominal neutral interest rate.

The neutral interest rate is the level of the OCR that is consistent with inflation being sustainably at target and the economy running at its potential output.

• When the OCR is below the neutral interest rate, it stimulates the economy, which puts upward pressure on inflation.
• When the OCR is above the neutral interest rate, it restrains the economy, which puts downward pressure on growth.

The reason the RBNZ kept the OCR high in 2023 and 2024 was to restrain the economy and thereby rein in inflation. 

Speaking in late January – before the OCR was reduced from 4.25% to 3.75% – RBNZ Chief Economist Paul Conway noted that the OCR was “still restrictive”, because RBNZ estimates placed the long-term neutral interest rate at between 2.50% and 3.50%.

“Given uncertainty, we will need to ‘feel our way’ as the OCR gets closer to our estimate of neutral,” he said.

“We will continually cross-check our estimate of the neutral interest rate by comparing the proximity of the OCR to neutral against what we are seeing in the real economy. 

“For example, if our estimate of neutral is too low, then we would see economic activity and inflation pressures pick up by more than expected, as monetary policy setting will have been less restrictive than originally intended. We also update our estimate of neutral as part of every policy round.”

The neutral interest rate is not something that's set in stone. Rather, it's a number that's both subjective and that changes over time, as the balance between savings and investment changes.

“Between 2008 and 2019, our central estimate indicates that the neutral OCR fell by two percentage points,” Mr Conway said.

“This slow decline in the neutral rate has recently stalled and may have even reversed. But the jury is still out on whether this increase will continue in future.”