WEEKEND ECONOMIST: Neutral gear

This week we saw probably the most important speech by an RBA official of the 37 that have been delivered this year.

The speech was relatively short and was delivered by the Deputy Governor of the Reserve Bank, Ric Battelino. In the speech he specifically recognised that the "neutral" cash rate should not be assessed independently of private sector lending rates.

He noted that since mid 2007 (roughly the beginning of the global financial crisis) the margin between the cash rate and private sector lending rates had increased by around 100 basis points. In the paper he noted that the gap between the cash rate and funding costs for banks had increased by 108 basis points on average. To restore margins banks had increased lending rates relative to the cash rate by around 120 basis points – all of that adjustment had occurred in the business segment with mortgage rate margins, "much the same today as it was at the start of the crisis". That adjustment of business spreads reflected higher risk spreads in the global economy.

For example, Australia's AA banks (only 10 banks are rated AA or better in the world of which four are Australian) are now paying 173 basis points more (according to RBA data) relative to the cash rate for long term wholesale funds than they were paying prior to the financial crisis. It seems reasonable that unrated or more lowly rated corporates or SME's should also pay more for their funding.

The Deputy Governor's observation that mortgage spreads have not increased indicates that mortgage borrowers are not paying a higher spread for risk. That would indicate that the "blow out" in spreads in the mortgage securitisation market from around 20 basis points before the crisis to around 140 basis points is mainly explained by liquidity and term issues although some other distortions may also be at work.

In accepting that the key for the economy is private sector rates rather than the cash rate "per se" the 100-basis-point blow out in the margin between private sector rates and the cash rate has prompted the Deputy Governor to note that the current cash rate of 3.75 per cent is probably consistent with 4.75 per cent before the crisis. He argues that the cash rate is therefore "now back in the normal range, though in the expansionary segment of that range."

When they have prepared to put a number on the neutral rate RBA officials have generally mused about a 5-6 per cent range, with the market generally targeting 5.5 per cent as the neutral rate. Arguably, this paper by the RBA redefines neutral at around 4.5 per cent.

At present neutral is a very important concept because it would be the rate that the Bank would see as being consistent with trend growth. Note that in the minutes from the December 1 Board meeting the Bank noted that, "that adjustment would not be intended to slow demand compared with the current forecast path, but aimed simply at keeping the stance of policy appropriate for improving economic conditions".

It is reasonable to conclude that the Bank may be targeting neutral as long as it is forecasting a return to trend growth – if growth forecasts changed then the target will move away from neutral.

Readers will recall that Westpac has been forecasting a return to a cash rate of 4.5 per cent by mid year to be followed by an extended pause.

Consequently the observations by the Deputy Governor are consistent with our own views.

However, we do see more to these issues than just an average level of private sector rates. Note that the Deputy Governor points out that all the margin widening has occurred in business rates. If we segment the economy between business and household there is little evidence that the wider margins are likely to adversely affect households directly. Indirect effects are important but it could be argued that the "neutral" rate for households is still at the "old" level with businesses taking the full adjustment.

We are inclined to favour that approach, so why are we still happy with the 4.5 per cent as being neutral? The answer is in the level of household debt. For our forecast of a move back to a cash rate of 4.5 per cent household debt servicing ratios will be at or very near the contractionary zone.

It is the increased accumulation of debt that will see households respond to a cash rate at a lower equivalent level than in earlier periods.

Without the rising debt levels, it is likely that the contractionary response to rate hikes from the household sector which the Bank now expects to occur at lower rates would not have occurred. The Bank would have had to conclude that the neutral rate for the household sector was not around 100 basis points lower than in previous cycles.

Bill Evans is chief economist as Westpac