The Neutral Rate (r*): Why Estimates Disagree

Key takeaways

• r* is a real rate - add expected inflation to get the nominal neutral cash rate.
• Policy is restrictive when the real cash rate sits above r*, stimulatory below.
• Estimates carry uncertainty bands wide enough to change the conclusion.
• r* drifts with demographics, productivity and global savings - it is not a constant.

What does the neutral rate mean in practice?

Central banks describe policy as restrictive or accommodative relative to neutral. That comparison only works if you have a view on where neutral is.

r* is defined in real terms - after inflation. To compare it to the cash rate you add expected inflation. If r* were, say, 1% and expected inflation 2.5%, the nominal neutral cash rate would be around 3.5%; a cash rate of 4.35% would then be restrictive by roughly 85 basis points.

Change the r* assumption by half a percentage point and that conclusion changes materially. Nothing about the actual cash rate moved - only the yardstick.

Why do the estimates disagree?

Because r* is extracted from data by models, and the models embed different assumptions about what drives it.

The RBA has published work on neutral rate estimation and is consistently explicit that the uncertainty is large enough to limit how much weight the concept can bear in real-time decisions.

What moves the neutral rate over time?

Slow-moving structural forces, not the business cycle.

• Trend productivity growth - higher productivity supports a higher return on capital and a higher r*.
• Demographics - an ageing population saving for retirement pushes r* down.
• Global capital flows - Australia is a small open economy, so the global savings glut argument applies here too.
• Risk appetite and safe-asset demand - strong demand for government bonds depresses the safe real rate.
• Fiscal policy - sustained public borrowing raises the equilibrium real rate.

For a borrower, the useful implication is not a number but a caution. If r* has drifted lower over decades, the very low mortgage rates of the 2010s were less anomalous than they felt, and equally the assumption that rates must "return to normal" depends entirely on which normal you mean.

Frequently asked questions

What is the neutral cash rate in Australia?

There is no agreed figure. r* is estimated in real terms with wide uncertainty bands, and converting it to a nominal cash rate requires an assumption about expected inflation. Treat any specific number as one model's estimate, not a known value.

Is a 4.35% cash rate restrictive?

That depends on your r* assumption and on expected inflation. Subtract expected inflation from the cash rate to get the real rate, then compare it with an r* estimate. Reasonable people reach different answers because the inputs are uncertain.

What is the difference between r* and the neutral cash rate?

r* is the real neutral rate. The neutral nominal cash rate is r* plus expected inflation. Comparing r* directly with the cash rate without that adjustment is a common error.

Does the RBA target the neutral rate?

No. The RBA targets inflation, using the cash rate as its instrument. The neutral rate is a reference point for describing how tight or loose the current setting is, not a target in itself.

Related reading

• How the RBA Actually Sets the Cash Rate: The Reaction Function
• NAIRU: Why Unemployment Drives Your Mortgage
• The Yield Curve: What Bond Markets Say About Rates

Sources

• Research on the neutral interest rate — Reserve Bank of Australia
• Statement on Monetary Policy — Reserve Bank of Australia