Economists and bond traders expect the Reserve Bank to cut interest rates quickly despite critical core inflation measures remaining above 3%

Financial markets are pricing in rapid interest rate cuts after Statistics New Zealand reported headline annual inflation had fallen into the Reserve Bank’s target range on Wednesday.

It was news many people had been waiting years to hear. Karen Silk, a Reserve Bank (RBNZ) assistant governor, said she was “tempted to dance a jig” when she saw the number.

Finance Minister Nicola Willis declared the era of “crushing price rises” over in a press release.

“There is more work to be done to get the economy growing, but New Zealanders can be confident we are headed in the right direction,” she said. 

Most forecasts had predicted annual inflation would fall to just above 2% in the September quarter and bond traders had already priced in jumbo rate cuts at the next RBNZ meetings. 

The odds of the bank cutting 100 basis points off the Official Cash Rate (OCR) by February rose, with an increasing chance of it being front-loaded with a 75 point cut in November. 

If that were to happen, it would put the OCR at 4% for the summer holidays and easily back to a neutral rate around 3% by the end of 2025. But some think even that won’t be fast enough. 

Stephen Toplis, head of market research at BNZ, said headline inflation at 2.2% was essentially at the target midpoint and with little risk of bouncing out.

He said this had encouraged speculation the central bank could deliver a triple rate cut, usually reserved for crisis situations, at the end of November.

“The rationale is that the economy is weaker than anticipated, inflation is lower and so the Reserve Bank must get its cash rate to neutral quickly,” he wrote. 

But he thought this was unlikely. The RBNZ projected regular size cuts in October and November and has already delivered a double cut, acknowledging the downside risks.

“If it goes a further 50 in November, as we project, then it will be acknowledging an even bigger miss …  for the Bank to go 75 it would seem to us that a much bigger negative shock would yet be required.”

The RBNZ has already cut the OCR by 75 basis points from a peak of 5.50%, with a 25 basis points cut in August and a 50 basis points cut this month.

Core inflation at 3%

Monetary policymakers will be less interested in the headline inflation number and more interested in underlying price pressures. RBNZ Governor Adrian Orr last year said the bank was effectively targeting core inflation of 2% — not headline.

This is actually the central bank’s remit, if you read it carefully. It is tasked with achieving and maintaining “future inflation” between 1% and 3% over the medium term, disregarding any temporary disturbances.

Words like “temporary” and “transitory” may be triggering for those who have watched central banks get it wrong in recent years, but this flexibility is still in the remit. 

In this case, it may lead to tighter—rather than looser—monetary policy as many measures of core inflation are still above the target range. 

Non-tradable inflation, a measure of mostly domestic prices, was still well above historical averages at 4.9%. This was driven by higher rents, property rates, and alcohol/tobacco taxes. 

Tradable inflation, prices which face international competition, dropped 1.6% as food and fuel prices fell sharply. This imported deflation offset the still strong domestic inflation.

Jarrod Kerr, chief economist at Kiwibank, said deflationary pressures were becoming more broad based and would pull “slow-moving” domestic prices back to the long run average. 

But measures of core inflation suggest pressures still linger in the New Zealand economy. 

Annual CPI increases to anywhere between 2.3% and 2.7% if you trim off the most extreme price movements on both sides of the ledger.

If you exclude volatile food, energy, and vehicle fuel prices from the index, it suggests an underlying inflation rate of 3.1%. This is a commonly used core inflation measure. 

But RBNZ has its own methods of estimating core inflation. Its flagship model put inflation still above target at 3.4%, while a less sophisticated version of the model put it at 2.4%.

The upshot is that policymakers at the Reserve Bank will not automatically agree that inflation has been completely eliminated. Core inflation represents the “future inflation” the central bank has been tasked with controlling, and it looks somewhere near 3%.

Policy noise in the data

Of course, there will always be numbers available to support a different theory. If you exclude central and local government charges, annual inflation would drop to 1.9%.

Government policies played an unusually large role in the September data release, as it was the first quarter of the fiscal year and captured a range of new taxes and transfers.

The majority of all price increases during the quarter came from local government rates, which increased an average of 12% — the largest hike in the past three decades.

Stats NZ includes property rate movements in the September CPI, when they are experienced by ratepayers, even though they are an annual increase. 

But rates were still a significant contributor to annual inflation. They made up over 18% of the total, roughly matching the other two big drivers: rental and insurance costs.

Research by Infometrics found local councils needed to raise more revenue to cover increased costs of construction, service debt at higher interest rates, and pay inflation-adjusted wages.

This comes at a time when councils are being confronted by urgent infrastructure upgrades that were deferred by previous officials in an effort to keep property rates low.

A number of Central Government policies also affected the CPI data. The fall in fuel prices was accentuated by the axing of the Auckland fuel tax in July, pushing tradable inflation lower. 

Pharmaceutical products were pushed up 17% due to a Coalition policy to reintroduce a $5 co-payment for prescription medicines, with that money used to subsidise childcare. 

It was that child care subsidy that had the biggest impact on the data. Stats NZ measured early childhood education prices as if the full rebate was collected by families. 

This pushed reported prices down 22.8% in September, even though the underlying prices being paid by families upfront increased almost 7%. Quarterly inflation would have been 0.2 percentage points higher if the underlying price was counted instead. 

Barbara Edmonds, Labour Party’s finance spokesperson, said on Tuesday the rebate was too hard to access and only 8700 families had received a payment.

Finance Minister Nicola Willis said there were an estimated 100,000 eligible families but less than half of those had registered for the scheme so far. She encouraged others to sign up. 

It is not incredibly consequential for the inflation data but does demonstrate how underlying price pressures can be hard to identify in headline numbers.

ASB economists said there were a “multitude of policy and cost-induced changes that muddied the figures” but underlying pressures looked to be settling at around 2%.

“The largest regret is that the RBNZ proves to be too slow in monetary policy easing that could cause economic scarring and sizable job losses.  We expect a 50 bps cut in November, and a 3.25% OCR endpoint, but risks are tilted to more front-loaded policy easing.”

Other economists, such as Nic Guesnon at UBS, believe the central bank will deliver three 50 point cuts in row and ultimately get the OCR to 2.75%.