Reserve Bank Acting Governor says if inflation doesn't pick up from late next year 'a further easing of monetary policy' would have to be considered

By David Hargreaves

The Reserve Bank's suggesting it may yet have to implement further interest rate cuts from next year if the forecasted increase in the rate of inflation doesn't materialise.

The comments, made by Acting Governor Grant Spencer on Wednesday in the RBNZ's last major communication with the market place for 2017 may come as a surprise to some economists. There are still people in the marketplace predicting that the RBNZ would actually increase interest rates next year.

The interest rate set by the RBNZ, the Official Cash Rate, is currently at a record low of 1.75%. In its most recent forecasts made last month the RBNZ was forecasting the OCR to be unchanged for a long period before rising slighlty from late 2019. The New Zealand dollar rose by about a third of a US cent to be just under US69c.

But in a speech to the Institute of Directors in Auckland, Spencer painted a picture of a central bank still grappling with a changed and rapidly advancing global environment in which inflationary pressures are no longer performing as they once did.

"In the context of the November Monetary Policy Statement, non-traded inflation is forecast to pick up from late 2018 in response to increasing capacity pressures," Spencer said.

"If this response does not eventuate then we would have to consider a further easing of policy to generate additional domestic demand pressure, particularly if global inflation remains low in line with our forecasts.

"However, we would need to be careful not to generate unwarranted instability in output, the exchange rate or indeed household debt."

Further into the speech, however, Spencer, highlighting that the RBNZ appears to be balancing risks, said that in its recent November Monetary policy statement, it assumed that weak global inflation will persist in line with the forecasts of the international institutions.

"This now puts some risk on the upside for inflation and interest rates. If the assumption proves incorrect and global inflation picks up in response to increased global growth, then we would likely see higher international interest rates, a lower NZ dollar exchange rate and higher traded goods inflation. This would put upward pressure on domestic interest rates," he said. It would appear to be this remark that has prompted the financial markets to send the value of the Kiwi dollar higher.

Spencer said persistently low inflation had prompted the RBNZ to think about whether it needs to tweak it’s approach to monetary policy.

Current global trends appeared to be "changing the nature of the price formation process in New Zealand". Spencer cited three significant global influences, namely the expansion of global supply chains, the rapid growth of China, and the growth of the digital economy.

"These factors may be reducing the leverage monetary policy has over inflation, although their persistence and impact on inflation in New Zealand remain uncertain,” Spencer said.

The RBNZ's monetary policy had less than fully offset the weakness in imported inflation, which was not expected to be so persistent and had been "overlaid with uncertain commodity price movements".

"The on-going shock has resulted in CPI inflation running below the [RBNZ's] 2% target mid-point. The policy response has been consistent with our flexible inflation targeting framework.

"More recently we have been assuming greater persistence in low global inflation and this is contributing to our current flat track for future OCR levels.

“The changes in domestic pricing behaviour are causing our flexible inflation targeting approach to become more flexible. In pursuing our long term price stability objective, relatively more weight is being attached to output, employment and financial stability.

"However, this can only be sustained if monetary policy’s long term price stability credentials are maintained," Spencer said.

He posed the question of how might the global developments impact New Zealand's monetary policy?

"Do we need to tweak our approach, or rethink our framework? 

"The first thing to say is that these changes to the inflation process are uncertain and it is unclear how long lasting they will be. 

"Also, with long-term inflation expectations anchored at 2%, there remains broad confidence in the effectiveness of the current framework. We should therefore be cautious about making any recommendations for change."

Spencer said that to the extent that the leverage of monetary policy over domestic inflation may have reduced, this suggests a cautious approach when responding to inflation deviations from target and careful attention to the RBNZ's assessment of economic slack.

"It may be appropriate for monetary policy to put relatively more weight on output, employment and financial stability relative to inflation. However, this can only be sustained if monetary policy’s long term price stability credentials are maintained."

This is the media release the RBNZ issued on the speech:

Inflation in New Zealand and world-wide has been persistently low since the 2008 global financial crisis, partly because of factors such as globalisation, the growth of China, the rise of the digital economy, and low inflation expectations.

In a speech today to the Institute of Directors, in Auckland, Reserve Bank Governor Grant Spencer said that persistently low inflation has prompted the Reserve Bank to think about whether it needs to tweak it’s approach to monetary policy.

Mr Spencer explained a number of significant changes over the past decade have affected the outlook for inflation:

• Globalisation over the past 10 years has led to outsourcing of labour-intensive production to cheaper locations, which has lowered the price consumers pay for a wide range of goods and also placed downward pressure on wages for lower-skilled jobs in advanced economies.
• The scale and growth of China’s economy has also had a profound effect. China has become the largest exporting nation in the world and its expansion of capacity has restrained the prices of industrial materials and a wide range of manufactured goods.
• New digital distribution channels and falling prices for ICT equipment have lowered import prices and reduced barriers to entry across a range of markets. Online competition in retailing, financial services, travel services, education and health has significantly altered the competitive landscape and put downward pressure on prices.
• The domestic economy has become more integrated with global markets, resulting in greater competition in traditionally sheltered sectors. Increased international labour mobility has been an important driver.
• Low inflation expectations have influenced the way businesses set prices and wages, adding further momentum to low inflation.

These global trends appear to be changing the nature of the price formation process in New Zealand.

“These factors may be reducing the leverage monetary policy has over inflation, although their persisitence and impact on inflation in New Zealand remain uncertain,” Mr Spencer said.

Monetary policy has less than fully offset the weakness in imported inflation which was not expected to be so persistent and has been overlaid with uncertain commodity price movements. The on-going shock has resulted in CPI inflation running below the 2% target mid-point. The policy response has been consistent with our flexible inflation targeting framework. More recently we have been assuming greater persistence in low global inflation and this is contributing to our current flat track for future OCR levels.

“The changes in domestic pricing behaviour are causing our flexible inflation targeting approach to become more flexible. In pursuing our long term price stability objective, relatively more weight is being attached to output, employment and financial stability. However, this can only be sustained if monetary policy’s long term price stability credentials are maintained” Mr Spencer said.