RBNZ cuts OCR to 3.75% but it is still contractionary.

Today, as predicted, the RBNZ cut the OCR by 50 basis points to 3.75%. But this new interest rate is still seen as a contractionary to the economy and with the prospect of global trade protectionism risks to growth are high.

How does the OCR work – RBNZ video

The term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented

The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.

• OCR > Neutral Rate = Contractionary and slowing down the economy

• OCR < Neutral Rate = Expansionary and speeding up the economy

The graph below shows the difference between the estimated neutral rate and the OCR.

This neutral rate dictates when the RBNZ end their tightening or loosening cycle. If the neutral rate is seen to be around 3% it is the expectation that the RNBZ will decrease the OCR to 3%. It is forecast though that the RBNZ will cut the OCR by 25bp increments at the April and May meetings, leaving the OCR at 3.25%.

What are some determinants of the neutral rate of interest in an economy?

• Supply of loanable funds (people who save money) and Demand to borrow money – neutral rate generates a level of savings and borrowing that delivers the economy to maximum sustainable employment and inflation – 2% in NZ but with Policy Target Agreement of 1-3%.

• Potential growth rate of an economy – if people expect more growth = higher incomes = higher borrowing = upward pressure on neutral rates. Economists tend to look at the production function and how much we can produce in the long-run therefore impacting aggregate supply. With higher potential growth rates investment spending is expected to increase and with it interest rates

Source: Westpac Economic Bulletin – 19-2-25

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