22 Jul 2015

How far will the Reserve Bank go?

2:11 pm on 22 July 2015

ANALYSIS: In early June the Reserve Bank had cut the Official Cash Rate from 3.5 percent to 3.25 percent citing low inflation pressures and weakening demand.

Reserve Bank Governor Graeme Wheeler.

Reserve Bank Governor Graeme Wheeler. Photo: RNZ / Diego Opatowski

Its governor, Graeme Wheeler, signalled more reductions may be needed, but the central bank's forecasts indicated only one more in the pipeline.

Most economists had thought it would be September, at the earliest, before Mr Wheeler would need to act.

What a difference six weeks make.

Plunging dairy prices - down 20 percent since June - and low annual inflation of 0.3 percent - well below the midpoint of the Reserve Bank's 1-3 percent target band - had economists scrambling to forecast even deeper cuts.

ASB Bank in a recent analysis said growth was likely to be softer than expected over 2015. "With strong competition in the absence of capacity constraints the non-tradable inflation outlook remains fairly benign. This reinforces our view for further rate cuts this year," it said.

The world economy is also shakier than six weeks ago, especially China and Australia which are New Zealand's biggest trading partners.

Nearly all the 15 bank economists polled by the Reuters news agency expect the Reserve Bank to shave the benchmark rate by a quarter of a percentage point to 3 percent on Thursday.

New Zealand money.

Photo: RNZ / Alexander Robertson

Almost half are now picking the Reserve Bank will cut the cost of borrowing to 2.5 percent by December, unwinding all of the hikes imposed last year.

Westpac is forecasting Mr Wheeler will go even further, and lower rates to 2 percent.

ANZ Bank chief economist Cameron Bagrie says that can't be ruled out, but rates that low would indicate an economy in trouble.

"That would be a scenario that the New Zealand economy is going very pear-shaped."

Most analysts don't expect that to happen, since other parts of the economy outside of the dairy sector are still in robust shape.

Foreigners continue to flock here in search of work or to holiday, while recent surveys indicate manufacturing and service sector activity continues to expand.

Falling dollar

But some economists warn inflation pressures may be building, even as the economy falters.

The dollar has fallen 8 percent to about 66.2 US cents since the last Reserve Bank meeting, and 16 percent this year.

Head of research at BNZ, Stephen Toplis, says the falling dollar may limit the central bank's choices by pushing up import costs.

"It's only a matter of time."

But other analysts are doubtful about the dollar's impact, saying a slowing economy and budget conscious shoppers are likely to limit the ability of retailers to pass on price increases.

The Auckland housing market

Auckland's overheated housing market may also be another stumbling block to deeper rate cuts.

Mortgage rates have continued to fall, with some banks already dropping their floating rates in anticipation of the Reserve Bank cutting on Thursday.

Homes at the Waimahia development in Weymouth in Auckland.

Homes at the Waimahia development in Weymouth in Auckland. Photo: RNZ / Kim Baker Wilson

In June, Graeme Wheeler conceded lower rates could bolster Auckland's property market, but the slowing economy needed a pick up to get inflation back to its mid-point of 2 percent.

Mr Wheeler also expressed confidence in proposed measures to limit lending to property investors.

Some economists are sceptical.

The BNZ's Craig Ebert says measures to limit lending demand can't substitute for interest rate rises forever.

"Macro-prudential stop-gaps can only do so much, for so long."

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