2 Interest rate concepts

The interest rates that are observed in day-to-day life are almost always expressed in nominal terms. This allows a saver to determine how much their savings will accumulate at the end of a specified period of time, but it does not tell them how much the return on their savings will be worth in terms of actual goods and services. In order to do this, savers must determine the expected real interest rate - they must subtract expected inflation (for the period over which the money is to be saved) from the nominal rate.

Assuming that it is real interest rates that drive our economic decision-making, this paper distinguishes between the OCR and two real interest rate concepts: the neutral real rate (NRR) and the actual real interest rate.

The NRR is not observable. It is a theoretical concept that draws heavily on the theory of the natural rate of interest developed by Knut Wicksell in 1907. Wicksell defined the natural rate of interest as the rate of interest that (1) equates saving with investment; (2) is equal to the marginal productivity of capital; and (3) is consistent with aggregate price stability.

Monetary policy decision-making implicitly takes a view about the prevailing level of the NRR. That is, it takes a view about the required level of real interest rates associated with price stability.

Based on its view of the NRR, the RBNZ sets the OCR either to stimulate the economy and prevent deflationary forces from gathering momentum or to constrain the economy and prevent inflation from accelerating (Björksten and Karagedikli, 2003). For the purposes of this paper, it is assumed that in setting the OCR, the RBNZ “gets it right” on average - that is, inflation and inflation expectations are generally stable around the inflation target. Internal balance, or price stability, is maintained. This assumption seems appropriate given the historical performance of the RBNZ.

The level at which the OCR is set by the RBNZ will affect the level of short-term interest rates in the economy. However, much economic activity, for example investment, depends on long-term interest rates. Moreover, actual interest rates differ not only in their term (short, medium or long) but also according to their risk type (government rates, mortgage rates, etc.). Each risk type can be represented along a yield curve. A yield curve is a plot of interest rates or yields with different maturities (but otherwise almost identical characteristics) observed at a single point in time (RBNZ, 2010).

The gap between the OCR and the observed actual real interest rate will depend on the risk type and term of that particular actual rate. It is likely that the long-term rate (for a particular risk type) includes a term premia (not to be confused with country risk premia) to compensate for holding an asset of longer maturity.

The actual real rate in the context of this paper is a “catch-all” for all observed real rates with different terms and risk types. In order to justify the usage of one single actual real interest rate in the framework that follows, the expectations hypothesis about the term structure of interest rates (for a given risk type) is invoked. The term structure of interest rates is of fundamental importance in macroeconomics because theories about the term structure of interest rates thus become theories about the connection between monetary policy (that affects short-term interest rates) and economic activity, specifically investment, which depends on longer-term interest rates.

The expectations hypothesis takes the view that the setting of the OCR (based on an assumption about the level of the NRR) ultimately “sets” actual rates (of a given risk type) along the yield curve. That is, any increase or decrease in the OCR level will be followed by a shift in the yield curve in the same direction as the OCR. Although the direction of change is assumed to be the same, the magnitude of the change does not have to be one-for-one.[3]

Finally, the premia associated with a specific risk type are more-or-less independent of the term structure of the rates and so the relationship between risk types can be considered more or less stable along their yield curves (refer to RBNZ, 2010 for a thorough exposition of New Zealand yield curves across risk types).

This “stable” relationship between the yield curves of different risk types of interest rates, along with the expectations hypothesis, allows us to assume, for simplicity, one real interest rate in the framework that follows.