Inflation has been defeated and the Reserve Bank is moving swiftly to normalise interest rates

After three and a half years of fighting, the Reserve Bank (RBNZ) has finally defeated inflation and may move quickly to cut interest rates to a neutral position. 

The Monetary Policy Committee said on Wednesday it believed annual consumer price inflation (CPI) was converging on the 2% midpoint of its 1% to 3% target range, and would stay there in the medium term. The RBNZ thus cut the Official Cash Rate (OCR) by 50 basis points to 4.75%.

Statistics NZ will release the official CPI number in the middle of next week. All forecasts expect it to land in the target and likely very close to the midpoint. Price stability has been achieved.

Readers should keep in mind that annual inflation printing at 2% actually represents the one year anniversary of price stability, and prices haven’t been increasing quickly in the past year.

If you still feel grumpy, that is understandable. Prices have increased more than 19% over the past three years, significantly higher than the roughly 6.5% that would have occurred if inflation had stayed on target.

A brief history of inflation

It was in June 2021 that the consumer price index first rose above 3%, as fiscal and monetary stimulus exacerbated pandemic supply constraints. The RBNZ halted its government bond buying programme the following month, but kept the OCR at 0.25%.  

It would have hiked interest rates at the August 2021 meeting, except the country was returned to Level 4 lockdown on the eve of the decision. It wasn’t until October, when annual inflation was at 5%, that it began to raise interest rates.

While this looks tardy in hindsight, the RBNZ was still one of the first central banks to react to what would quickly become a global inflation crisis. From there it lifted the benchmark interest rate another 500 basis points across the next dozen meetings.

Annual inflation peaked at 7.3% in June 2022 and remained above 6% for the next year. It began to fall quickly in mid-2023 and is expected to touch down on target next week.

Tough times

But we can’t call it a soft landing. Economic activity per capita has been falling faster than after the Global Financial Crisis and unemployment could hit 6% — up from 3.2% in 2021.

Households had to redirect spending money to their mortgages, and businesses have been shedding staff to stay afloat as demand dried up. It has been a difficult couple of years.

The RBNZ has played a role as both arsonist and fire-fighter. It first pumped demand into the supply-constrained pandemic economy and then aggressively tamped it back down.

Some level of inflation was likely inevitable but mistakes were made. An independent review said policy should have been tightened earlier, although the ultra-loose pandemic settings were “largely warranted”.

Lower-for-sooner

There will be more time to assess the totality of the response once the dust has settled. But for now, it looks like the central bank wants to move quickly to avoid another mistake. 

Brad Olsen, principal economist at Infometrics, said there was “real potential” for the committee to consider a 75 basis point cut in November ahead of the summer break. 

“[RBNZ] appears to have realised that the economy is weaker and doesn’t require as much interest rate restraint, and that it needs to cut faster to normalise interest rates — a clear, if only implied, omission that it may have been too slow to act,” he wrote in a note. 

Most economists expect the central bank to deliver another 25 or 50 basis point cut in November, as larger moves have only been used in crisis situations.

Stephen Toplis, head of research at BNZ, said the summary of the meeting clearly acknowledged that the looser monetary policy settings were still slowing the economy.

“When put alongside the fact that, ‘members agreed that increasing excess capacity is leading to lower inflationary pressure’, it can only mean the Bank expects to lower rates further,” Toplis said.

“Moreover, the Bank goes on to say that, ‘an OCR of 4.75% is still restrictive and leaves monetary policy well placed to deal with any near term surprises’. This is a clear signal from the Bank that there would be no need to raise interest rates from current levels even if it got a near term inflationary surprise”. 

BNZ believes there will be another double-whammy cut in November and regular size cuts at each subsequent meeting until the OCR hits 2.75%. 

Toplis said it would not be enough for the RBNZ to move rates to a neutral position and then stop there. It will need to stimulate the economy to prevent deflation and instability.

In May the RBNZ said it had increased what it describes as the long-run nominal neutral OCR by 25 basis points to 2.75%. The neutral rate is the level at which the RBNZ deems the OCR would neither stimulate nor constrain the economy.

Double-happy

Finance Minister Nicola Willis took to Twitter to celebrate the interest rate cuts. 

“Double-whammy, double-happy. The Reserve Bank’s decision to drop the OCR by 50bp today is great news for all Kiwis: mortgage holders, business owners and workers alike.”

“It’s clear the economy is turning a corner and brighter days are ahead,” she wrote in a post. 

Also on Twitter, Prime Minister Christopher Luxon seemingly took credit for the interest rate decision and claimed the Labour Government “oversaw” the Reserve Bank’s previous hikes. 

The central bank operates entirely independently from the government and the Coalition has only just begun to cut spending — this means its impact on inflation, if any, has been minimal.

Politicians will be keen to get credit for falling interest rates, as this will have a much greater  impact on households and the economy than even the largest central government policies.

But with rates still throttling economic activity, a whole-hearted recovery will likely have to wait until the middle of next year at the earliest. The sooner we get there, the better.