Reserve Bank lowers its estimate of the neutral cash rate
The Reserve Bank has reduced its estimate of the neutral cash rate in a “significant” move that could affect the trajectory of future rate cuts.
A Commonwealth Bank of Australia (CBA) analysis of Reserve Bank (RBA) models has found the nominal neutral cash rate to be approximately 2.9 per cent, below the RBA’s previous estimates of 3.5 per cent.
“The RBA has recently refined how the models account for the pandemic period, following the techniques of other central banks. This has led to a shift downward in some estimates of neutral,” the Reserve Bank said in their February statement on monetary policy.
The “neutral cash rate” refers to the estimated interest rate level that would neither stimulate nor restrain demand within the economy.
“We consider the shift in the RBA’s calculation of its estimates of the neutral cash rate as significant,” CBA economists Gareth Aird and Stephen Wu wrote in a release.
“The downward assessment of the neutral cash rate more closely aligns to our thinking on where the neutral cash rate sits,” they added.
A neutral rate of approximately 3 per cent aligns more closely with CBA’s analysis of the debt serviceability ratio (DSR), which tracks housing debt servicing costs as a proportion of household disposable income.
With housing costs ballooning over the past few decades, the DSR has climbed to record highs since May 2023, currently resting at 11 per cent.
The CBA economists believe that a cash rate closer to 3 per cent is consistent with a DSR of 8 per cent, which is roughly equal to the pre-pandemic 10-year average.
According to CBA, given that the neutral cash rate is now thought to be lower than previously assumed, this should provide the RBA board with more confidence to lower interest rates throughout 2025.
Commonwealth Bank expects the RBA to lower the interest rate throughout 2025 in three 25-bp reductions that will take the cash rate to 3.35 per cent.
In CBA’s view, the outlook for rate reductions becomes uncertain beyond 2025. If the RBA finds that the neutral cash rate is closer to 3 per cent, this could open up the possibility of future rate cuts. However, fiscal policy will likely influence the trajectory of interest rates.
“The prospect of a change in government naturally adds more uncertainty than usual to the fiscal outlook,” the CBA economists wrote.
“A loosening in fiscal policy would put upward pressure on demand and by extension inflation. If such a scenario materialised, the cash rate could remain at a restrictive setting for a more prolonged period.”
