Natural or equilibrium RBA cash rate is around 3.25 percent, says Michael Knox, Morgans Chief Economist
Personal reflections by Adept Economics Director Gene Tunny
At the Economic Society of Australia (QLD) business lunch on 12 August, Morgans Chief Economist Michael Knox asked Reserve Bank of Australia (RBA) Deputy Governor Andrew Hauser about Australia’s equilibrium real cash rate. Understanding this rate is crucial as it represents the level at which the RBA’s monetary policy is neither expansionary nor contractionary.
The cash rate is the interest rate on overnight borrowings, expressed in annualised terms. The RBA usually manipulates this rate when it is undertaking monetary policy. Other interest rates related to longer-term borrowings tend to move in the same direction as the cash rate, although not always one-for-one.
The real cash rate is the cash rate, 4.35 percent in August 2024, adjusted for inflation. As an approximation, the inflation rate is subtracted from the cash rate or any other interest rate to give the real rate. A real interest rate recognises that part of any interest payment is merely compensation for inflation that erodes the value of money. If you earn 5 percent interest over a year, but inflation is 3 percent, you only earn 2 percent in real terms.
The Australian cash rate of 4.35 percent compares with yearly inflation to the end of June 2024 of 3.8 percent, suggesting a real cash rate of around 0.5 percent. However, the expected real cash rate matters for the effectiveness of monetary policy. This is because when you lend or borrow money, what matters to you is what inflation occurs over the term you lend or borrow, not the inflation that has already happened.
We can estimate the expected real cash rate by subtracting expected inflation over the next year from the current cash rate. The current cash rate at 4.35 percent is higher than market economists’ expectations of inflation one year from now of 2.7 percent (Figure 1).
This means the expected real cash rate is around 1.5 to 1.75 percent as of July-August 2024 (Figure 2).
What is the natural or equilibrium real cash rate, then? The equilibrium real cash rate will be what the real cash rate should cycle around over the long run. That would be the real cash rate consistent with a Goldilocks economy, with the economy growing at its trend growth rate, unemployment at its natural rate, probably somewhere between 4.5 to 5 percent compared with the current rate of 4.2 percent, and inflation in the RBA’s target range of 2 to 3 percent.
As Michael Knox explained when I caught up with him to record an episode of my Economics Explored podcast, his understanding is the RBA thinks the current equilibrium real cash rate in Australia is 0.75 percent. This means that the current real cash rate of around 1.5 to 1.75 percent corresponds to a contractionary monetary policy, consistent with the RBA wanting to ensure inflation returns to the target band of 2-3 percent from its current rate of 3.8 percent.
Incidentally, this equilibrium real cash rate appears low compared with historical experience. Australia’s average real cash rate, based on inflation expectations, over the ten years to the beginning of 2008, the year of the financial crisis, was around 2.5 percent. Today’s low equilibrium real cash rate may be justified by economic developments such as the rise of the Chinese middle class and an expansion of global savings looking for investment opportunities, driving down real borrowing costs compared with decades past. This is the so-called savings glut hypothesis. Of course, things could change in the future. During the discussion, Michael emphasised the challenges in estimating the equilibrium real cash rate, noting that “it’s like trying to hit a moving target, especially when global debt levels and demographics are constantly shifting.”
Michael pointed out that the RBA thinks Australia’s nominal equilibrium cash rate is around 3.25 percent, with a real rate approximately at 75 basis points (i.e. 0.75 percent). The nominal equilibrium cash rate can be worked out as the sum of the equilibrium real cash rate of 0.75 percent and expected inflation of 2.5 percent, the mid-point of the RBA target band. This sum is 3.25 percent. However, Michael underscored the inherent uncertainty in equilibrium cash rate estimates.
So when the RBA starts cutting interest rates, it will cut them to at least the equilibrium cash rate of around 3.25 percent, which could be done with three 25-basis-point cuts and one 35-basis-point cut. However, if the economy slows down enough or goes into recession, the RBA would cut the cash rate below the equilibrium rate to stimulate the economy.
The podcast conversation with Michael also touched on the influence of US debt levels. Michael cited leading economists Larry Summers and Olivier Blanchard, who argue that high US debt could push the equilibrium federal funds rate to 4 percent. Given the Fed’s inflation target of 2 percent, this implies an equilibrium real federal funds rate of 2 percent. This has implications for Australia. Global capital flows and comparative interest rates significantly impact the value of the Australian dollar. We can experience inflation in the prices of imported goods if the dollar depreciates. Can Australia run a monetary policy with an equilibrium real monetary policy rate of 0.75 percent compared with higher rates, possibly 2 percent, in the US and not experience a depreciating dollar? Time will tell.
Understanding Australia’s real equilibrium cash rate matters because it directly affects the RBA’s monetary policy. A misjudgment could stifle growth or fuel inflation, highlighting the delicate balance the RBA must strike.
For a more in-depth discussion, you can listen to the full episode here:
RBA Deputy Governor Andrew Hauser in conversation with Morgans Chief Economist Michael Knox
Published on 29 August. For further information, please email us at contact@adepteconomics.com.au or call us at 1300 169 870.