RBNZ sees more interest rate reductions likely, but rules out extensive cuts; says further falls in NZ currency still 'necessary'; Westpac sticks with 2% OCR prediction

Reserve Bank Governor Graeme Wheeler says there's scope for more interest rate reductions and he believes further depreciation of the New Zealand dollar is necessary.

However, in a speech in Tauranga, Wheeler appeared to dampen speculation in some quarters that there would be extensive further rate cuts, saying that such a course could "only be consistent with the economy moving into recession". Wheeler said the RBNZ believed the economy was currently growing at an annual rate of around 2.5%.

“We will review our growth forecasts in the September Monetary Policy Statement but, at this point, we believe that several factors are supporting economic growth. These include the easing in monetary conditions, continued high levels of migration and labour force participation, ongoing growth in construction, and continued strength in the services sector.”

The New Zealand dollar, which had been edging up slightly against the American currency before release of the governor's speech at 9am, firmed by nearly half a cent after release of the speech, but then fell back slightly and was a short time ago trading at US67.1c.

The RBNZ cut interest rates for the second consecutive month in its regular review last week, taking the Official Cash Rate down to 3%. Economists are generally expecting that the OCR will be reduced to 2.5% by the end of the year, though Westpac economists believe the OCR will need to be reduced to what would be a historic low of 2%.

Time for a pause?

But while Wheeler's latest comments would suggest another cut to rates in the September review (to 2.75%), the tone of comments also appears to leave open the possibility of the RBNZ then pausing at 2.75%, which is likely to be why the NZ dollar rose after the release of the speech.

However, the subsequent easing in value of the dollar suggested that perhaps more of the nitty gritty of Wheeler's speech and particularly his dollar comments was being digested.

"Our models suggest that the real exchange rate is currently in the vicinity of its long-run equilibrium value – if growth, inflation, and the terms of trade were at their long-run trends," Wheeler said.

"However, the exchange rate remains above the level consistent with current economic conditions and, in particular, the current low level of export prices. Reflecting this, our economic forecasts, based on recent levels of the exchange rate and terms of trade, show the current account deficit becoming larger over the next two years. At current levels of export prices, a more substantial exchange rate depreciation is therefore required to stabilise the net external liabilities position relative to GDP."

Speaking directly on interest rates, Wheeler said a relevant issue was how rapidly the RBNZ should seek to return inflation to the mid-point of the 1-3% target band.

"There are important trade-offs here that can come at the expense of unnecessary volatility in output, interest rates, and the exchange rate – outcomes that, under the [Policy Targets Agreement], the bank is required to seek to avoid.

"Attempting to return inflation to the midpoint quickly could create the risk of overshooting the inflation goal, un-anchoring inflation expectations, and increasing the volatility of interest rates and the exchange rate, as monetary policy is significantly eased and subsequently tightened.

"On the other hand, while moving interest rates only gradually might have the benefit of inducing less volatility in output and key relative prices, it would increase the risk that the Bank consistently undershoots its inflation target, and that inflation expectations get anchored at too low a level.

"Our judgement in the current circumstances is that aiming to return inflation to around its medium-term target level in about nine to 12 months’ time is an appropriate speed of adjustment."

Westpac economists hold firm

In reaction to the speech, Westpac's economists were standing firm on their pick of a 2% low point for the OCR. Senior economist Michael Gordon said their view was "not based on a forecast of recession, but on what will be needed to meet the RBNZ’s inflation target over the medium term".

"We expect that the flow of information over the next few months will persuade the RBNZ to lower its interest rate projections further."

Gordon said annual inflation was currently just 0.3%, and it had been consistently below the 2% midpoint of the target range for almost four years.

"The RBNZ expects inflation to be close to the 2% midpoint by the first half of 2016 (a mild downgrade from the “early 2016” in last week’s OCR statement), with the recent fall in the NZ dollar pushing up the prices of tradable goods. The RBNZ judges that this is an appropriate pace of adjustment back to its medium-term inflation target.

"However, a fall in the exchange rate will only generate a transitory burst of inflation (with a lag of up to a year). Meanwhile, non-tradables inflation is already weak, and the softer growth outlook and the peak in the construction boom suggest any material pickup is some way off. So maintaining inflation close to 2% is likely to require sustained tradable goods inflation – which in turn requires a sustained decline in the NZ dollar – or a significant pickup in domestic activity. But neither of those will happen if the RBNZ cuts the OCR by only another quarter percent or so," Gordon said.

Deutsche Bank NZ chief economist Darren Gibbs said he does "share the view that the OCR will need to fall as far as some commentators have suggested" and disagrees with the RBNZ that the views of those commentators would be consistent with an economy in recession.

"In an economy experiencing population growth of around 2% p.a. (and even stronger growth in the labour force) the unemployment rate would quickly rise if GDP growth was to slow below 2% p.a., adding downward impetus to domestic inflation.

"In the event of a genuine recession we expect that the OCR may well fall much more than the most aggressive forecasts currently in the market," Gibbs said. 

This is the media statement the RBNZ issued on Wheeler's speech:

The Reserve Bank today confirmed that at this stage some further monetary policy easing is likely to be required to maintain New Zealand’s economic growth around its potential, and return CPI inflation to its medium-term target level.

Further exchange rate depreciation is necessary, given the weakness in export commodity prices and the projected deterioration in the country’s net external liabilities over the next two years, Governor Graeme Wheeler said.

Speaking to an ExportNZ/Tauranga Chamber of Commerce audience, Mr Wheeler said that in mid-2014, New Zealand’s terms of trade were at a 40-year high, but over the past 15 months the economy has experienced several shocks. Export prices for whole milk powder have fallen 63 percent since February 2014, and oil prices are currently more than 50 percent below their June 2014 level. Net immigration and labour force participation are at historic highs, and the real exchange rate has declined steadily since April 2015.

Over the past two years, annual CPI inflation has been in the lower half of the 1 to 3 percent target band, except for the period since the December quarter 2014 when the fall in oil prices brought CPI inflation to very low levels. The Bank expects annual CPI inflation to be close to the midpoint of the 1 to 3 percent target range by the first half of 2016.

“Under the Bank’s flexible inflation targeting framework, the Policy Targets Agreement specifically recognises that annual CPI inflation will fluctuate around the medium-term trend due to factors such as exceptional movements in commodity prices – like those experienced since mid-2014,” Mr Wheeler said.

“There are, however, several risks and uncertainties around the inflation outlook. These include the future path of the exchange rate, which will be influenced by future commodity prices, and the speed with which the recent depreciation feeds through to higher inflation.”

Mr Wheeler said that, despite recent declines, the exchange rate remains above the level consistent with current economic conditions.

“At current levels of export prices, a more substantial exchange rate depreciation will be required to stabilise the net external liabilities position relative to GDP.”

Mr Wheeler added that there is potential for further downward pressure on global dairy prices. “Also, over coming months, the Federal Reserve and the Bank of England are likely to begin the process of normalising their interest rates, which could assist our currency lower.”

Turning to interest rates, Mr Wheeler said that current monetary policy settings are providing stimulus to the economy at a time when output looks to be growing around 2.5 percent, slightly below potential, and core inflation remains a bit below the mid-point.

He said that some local commentators have predicted large declines in interest rates over coming months that could only be consistent with the economy moving into recession. “We will review our growth forecasts in the September Monetary Policy Statement but, at this point, we believe that several factors are supporting economic growth. These include the easing in monetary conditions, continued high levels of migration and labour force participation, ongoing growth in construction, and continued strength in the services sector.”

Mr Wheeler said that, in returning inflation to the mid-point of the target band, the Bank has to avoid unnecessary volatility in output, interest rates, and the exchange rate.

“Our judgement in the current circumstances is that aiming to return inflation to around its medium-term target level in about nine to 12 months’ time is an appropriate speed of adjustment. This may not always be the appropriate speed of adjustment. Nor does it mean that the Bank will necessarily deliver a precise outcome as the economy is constantly experiencing shocks and disturbances that policy may need to counter or accommodate.

“Having the scope to amend policy settings, however, is a key strength of the monetary policy regime. In response to these developments, the Bank will review and, if necessary, revise its policy settings to meet its price stability objective. The time path of inflation may change as monetary policy is recalibrated, but the overall goal of meeting the specifications of the PTA will remain the central focus of policy.”

Mr Wheeler also noted that the Bank is conscious of the impact that low interest rates can have on housing demand and its potential to feed into higher house price inflation. Lower interest rates risked exacerbating the already extensive housing pressures in Auckland by stimulating housing demand, although, outside of Auckland, nationwide house price inflation is currently running at an annual rate of around 2 percent. However, in the present situation, raising interest rates would be inappropriate as it would put upward pressure on the exchange rate and further dampen CPI inflation.

“The Bank continues to be concerned about the financial stability risks and risks to the broader economy that would be associated with a major correction in Auckland house prices. In the current circumstances, macro prudential policy can be helpful in reducing some of the pressures arising from the Auckland housing market. The proposed LVR measures and the Government’s policy initiatives that it announced in the 2015 Budget should begin to ease the impact of investor activity.

“While a strong supply response over several years is needed to address Auckland’s housing imbalance, macro-prudential policy can help to lower the financial and economic risks while important regulatory and infrastructure issues are addressed and additional investment in new housing takes place.”