The room to cut interest rates across countries

With most central banks now cutting interest rates, some have recently reduced policy rates by 50bp instead of the typical 25bp increment.

This might seem surprising given that larger rate cuts are usually reserved for times of crisis, but some banks are clearly wanting to make sure that they are reducing the real policy rate – which is the policy rate less expected inflation – given that the real rate drives the economy.

In other words, if a central bank cuts rates in response to lower expected inflation, it must reduce the nominal policy rate by more than the fall in expected inflation in order to lower the real policy rate.

In judging the stance of policy, the first chart shows the real policy rate – calculated as the nominal policy rate less the central bank’s forecast for underlying inflation over the next twelve months – for several advanced economies, including Australia.

It compares the real policy rates prevailing at the start of recent rate cuts (where applicable) with current real rates, alongside central bank/economist estimates of the neutral real policy rate.[1]

The chart shows that most countries had high real policy rates before starting to cut rates, with Australia and Norway – both yet to begin easing policy – exceptions, as they have the lowest real rates.

In Australia’s case, this was by design, as the RBA board consciously decided not to raise rates as aggressively as other countries in order to preserve as many of the COVID-era gains in the labour market given its dual mandate of price stability and full employment.

Among the central banks that have started to cut rates, Canada, the euro area, and Sweden have made the most progress in reducing their real rates.[2]  

As a result, Norway and Australia now find themselves with real policy rates in the middle of the global pack.

The second chart shows the gap between the real policy rate and central bank/economist estimates of the neutral real policy rate for the same economies, both now and when rate cuts began.

In all cases, real rates have remained above neutral rates as central banks have sought to control inflation.

On this metric, monetary policy remains restrictive across the advanced economies, but is least tight in Australia, reflecting the RBA’s cautious approach of trying to slowly reduce inflation without triggering a sharp rise in unemployment.

The euro area, Sweden and Canada have reduced the gap with their neutral rates the most.  In contrast, policy remains very restrictive in the US, New Zealand, and the UK, with Norway, which is yet to cut rates, not far behind.

If central banks successfully achieve soft economic landings where inflation sustainably returns to target, they will aim to close the gap between real policy and neutral rates.

In such a scenario, the US and New Zealand would have the most room to cut rates, potentially reducing the real policy rate by about 175bp, or around 200bp in nominal terms given both countries currently forecast inflation to remain slightly above target for some time.

The UK, Norway, the euro area, and Sweden would have less room to cut rates, with the real policy reductions estimated at about 75-125bp. Nominal rate cuts for these economies could range from about 75-175bp, depending on forecast inflation, which remains above target for some time for most of these countries.

In Australia’s case, eventual rate cuts could see the RBA lower the real policy rate by about 50bp, with the nominal rate about 85bp lower given the RBA currently forecasts inflation above the 2½% midpoint next year.

If central banks miscalculate and soft landings turn into hard landings or even recessions, then they will naturally cut by much more in order to reduce real policy rates below their neutral benchmarks.

A critical factor in this analysis is the likelihood that neutral rates have risen in many countries, as suggested by model results and market pricing.

If neutral rates are indeed higher, then central banks are unlikely to need to cut real policy rates by as much in a soft landing scenario, provided they adjust up their estimates of neutral.

However, if central banks underestimate the neutral rate and cut too aggressively, then they risk jeopardising a successful soft landing, inadvertently rekindling inflation.

Note:
[1] Headline inflation forecasts were used for New Zealand.
[2] Not all the ECB’s policy rate reduction reflects monetary policy decisions, as there was also a 35bp technical reduction in the main refinancing rate related to how policy is implemented.