Mid-year economic update: Reserve Bank of Australia

Providing a mid-year economic update, Dr Debelle said, “while the goals of monetary policy are very much domestic, in terms of inflation and employment, the influences on the achievement of these goals are both domestic and global.”

“(There are) four common global factors that have led to the expansionary monetary policy settings, seen in most advanced economies, for almost a decade.

“The subdued global recovery post crisis – which is now 10 years old; the low level of investment around the world; subdued wages growth despite unemployment rates and then, how all of that flows into the low inflation we see today.

“Another significant factor contributing to the low level of policy rates globally is that the neutral policy rate in many countries has declined over the past decade.

                                  

“The neutral interest rate provides a benchmark for assessing the current stance of monetary policy. If the real policy rate – that is, the cash rate less inflation expectations – is below the neutral rate, then monetary policy is exerting an expansionary influence on the economy.

“If the real policy rate is above the neutral rate, then monetary policy is exerting a contractionary influence on the economy.

“As you may have read in the paper, there was a discussion of the neutral rate at the most recent (RBA) Board meeting, as detailed in the minutes of the meeting released earlier this week.

“Despite all the kerfuffle around that, no significance should be read into the fact the neutral rate was discussed at this particular meeting.

“That said…the neutral interest rate aligns the amount of saving and investment in the economy at a level that is consistent with full employment and stable inflation. That is, the neutral rate is where the policy rate would settle down in the medium term when the goals of monetary policy are being achieved and are going along how we would like it to go.

“Accordingly, most explanations of the neutral interest rate start with the factors that influence savings and or investment.

“Developments that increase saving will tend to lower the neutral interest rate; developments that increase investment will tend to raise the neutral interest rate.”

Dr Debelle said there are three factors that affect the neutral interest rate in Australia:

• the economy's potential growth rate;
• the degree of risk aversion; and
• global international factors.

“One of the major determinants of the neutral interest rate is the economy's potential growth rate,” he said.

“If we have high potential growth rate, because it has strong productivity or population growth…that generates more demand, generates more investment and the prospect of higher real incomes reduces the incentives of households to save – that tends to push the neutral rate up.

“Another influence on the neutral rate is the risk appetite of firms and households and the way risk has been priced into market interest rates – and that can move rapidly.

“When risk aversion rises, firms require more compensation to make long-term investments with an uncertain return – households are going to be likely to save more.

“This lowers the neutral interest rate, as any given level of the policy rate is less expansionary because of the increased risk aversion. If there is an increase in risk aversion, it is also likely that there will be a widening in the spreads between the policy rate and market rates, given the market interest rate will correspond to a lower policy rate if spreads widen. This will further lower the neutral interest rate.

“Finally, in an open economy like Australia, where capital can move reasonably freely across borders, global interest rates will also influence domestic interest rates. So, that means that trends in overseas productivity growth, demographics and risk appetite will affect the neutral interest rate here in Australia.”

Dr Debelle also discussed global financial influences.

“In addition to the neutral rate declining, policy rates in other countries have been set even lower…to provide the appropriate stimulus. On top of that, in a number of the major economies, policy is more expansionary than indicated by just the level of the policy interest rate,” he said.

“The fact that monetary policy settings are more expansionary in the rest of the world than in Australia, both through lower policy rates and balance sheet expansion, has been putting upward pressure on the Australian dollar.

“Capital is attracted here by the higher rates of return on offer…which is likely to lead to an appreciation of the exchange rate. So, while an easier monetary policy elsewhere in the world… should lead to faster growth in the world economy, which is good for the Australian economy, an appreciating Australian dollar works against this.

“To put it in economic terms, there are offsetting income and substitution effects for the Australian economy. Whether…this is positive or negative in net terms for Australia is an empirical issue. Generally, the evidence suggests that widening interest rate differentials do lead to an appreciation of the Australian dollar. So, that does counteract the benefit to the Australian economy of faster global growth.

“It is conceivable that unconventional monetary policy… may have a larger financial impact than movements in interest rates. That is, the effects of balance sheets expansions on the exchange rate may be larger while the effect in terms of higher output, in terms of stimulating growth in these economies, may be smaller. Again, it is an empirical issue.

“The effects of these global influences on the Australian economy have been material. The global economic environment and global policy settings that have been in place for the past decade have contributed significantly to the monetary policy settings in Australia that we have today and will continue to do so for the foreseeable future.

“Currently, financial markets don't expect any further lowering of policy rates in the major economies, nor any further expansion in policy settings. Hence the downward pressure on domestic policy settings…(but it) does not look like it will intensify in the foreseeable future.

“Ultimately, in Australia as is the case elsewhere, policy rates are set at the level assessed to be appropriate to achieve the domestic policy objectives.

“While global influences, including monetary policy settings in other economies, have a significant impact on that assessment, they are, in the end, only one of a number of considerations to be taken into account.”