The Reserve Bank does not expect the New Zealand economy to come out of recession soon.
New Zealand's central bank cut the Official Cash Rate by a percentage point to 6.5% on Thursday, but warned the size and timing of future cuts will depend on inflation pressures abating.
Reserve Bank governor Alan Bollard says the record cut in the benchmark rate was taken with the turmoil on financial markets and weakening outlook for the global economy in mind.
The Official Cash Rate was previously cut by half a percentage point to 7.5% on 8 September.
Dr Bollard expects inflation to fall from 5% to within the bank's 1% to 3% target band by the middle of next year as the effects of the global financial meltdown reach New Zealand.
He expects to lower rates further, but says future cuts will depend on developments in the financial markets and how quickly still stubborn domestic inflationary pressures subside.
"We've just got to remember we are doing this from a point of very high historical inflation. Now, everybody expects those numbers to come off, but what we're looking at is any evidence that those get entrenched."
Dr Bollard says he is comfortable with the dollar's fall in recent weeks and does not see it as a contributor to inflationary pressures given falling oil prices and a weak economy.
The last recession, in 1997-98, lasted nine months. Gross Domestic Product was down 0.2% for the June quarter and 0.3% for the March quarter.
Statistics New Zealand announced on Tuesday the annual rate of inflation is 5.1% - the highest for 18 years.
Banks drop mortgage rates
Almost all of the major banks responded to the cut in the Official Cash Rate by reducing interest rates on mortgages.
ANZ and National banks have cut interest on their two-year home loan rates by 0.5%.
Kiwibank dropped its two-year fixed rate by 0.3% and ASB dropped its two-year fixed rate by 0.6%.
Both Kiwibank and Westpac dropped their variable interest rates by a full percentage point, but the other banks are yet to announce whether they will reduce theirs.
Trading banks ASB and TSB reduced their fixed-home loan rates and say their floating rates are currently under review.
Economist Ganesh Nana, from economic research company BERL, says he thinks the Reserve Bank could still bring down interest rates further and faster.
Central banks around the world slashed their interest rates in an unprecedented, co-ordinated move on 8 October.
The Bank of England cut its rates from 5% to 4.5% and the US Federal Reserve went from 2% to 1.5%. Similar reductions were made by Canada, Sweden and Switzerland.
The Reserve Bank of Australia cut its rate from 7% to 6% on 7 October.
Comment on OCR cut
Deutsche Bank chief economist Darren Gibbs says the faltering economy means a more aggressive easing of the Official Cash Rate rate is likely this year.
Wellington Chamber of Commerce chief executive Charles Finny says borrowing is one of the big costs faced by businesses and the sector will keep a close eye on all banks to ensure that they quickly pass on interest rate cuts to customers.
Federated Farmers supports the latest cut in the benchmark interest rate.
President Don Nicolson says overseas economies are going to hell in a handbag, but the provincial economy is keeping New Zealand from falling into the same abyss.
Mr Nicolson says the cut should give farmers confidence to continue with the capital investment needed to farm the country out of recession.
Statement by Reserve Bank governor
Reserve Bank governor Alan Bollard commented that "ongoing financial market turmoil and a deteriorating outlook for global growth have played a large role" in shaping the decision to reduce the Official Cash Rate from 7.5% to 6.5%.
"Economic activity in New Zealand will be further constrained, relative to the outlook presented in our September Monetary Policy Statement, by these international developments.
"New Zealand can expect to face lower demand for exports and credit is likely to be less readily available. In this environment consumers and businesses are likely to be more cautious and curtail spending.
"The reduction in domestic spending will be partly offset by the depreciation of the New Zealand dollar over the past few months, falling oil prices and the recent loosening of fiscal policy.
"With weaker short-term growth and sharply lower oil prices we now expect that annual CPI inflation will return to the target band of 1% to 3% around the middle of 2009.
"However, we still have concerns that domestically generated inflation (particularly in labour costs, local body rates, electricity prices and construction costs) is remaining stubbornly high.
"Consistent with the Policy Targets Agreement, the Bank's focus will remain on medium-term inflation. Should the outlook for inflation evolve as projected we would expect to lower the OCR further.
"However, the timing and extent of OCR reductions over the coming months will depend on evidence of actual reductions in domestic cost pressures as well as how the global financial developments play out."