Clear cut

Since July last year we have consistently predicted that the Reserve Bank would have to cut the OCR below 2.5% in 2016. Last week’s data provided crucial evidence in favour of that view. Inflation turned out much weaker than the RBNZ expected. Housing data further confirmed a slowdown in Auckland. And another negative dairy auction compounded the dairy sector’s woes. True, the data also confirmed that the New Zealand economy has good momentum behind it. But at the same time, global financial and economic conditions appear to be deteriorating rapidly.

We have been anticipating low inflation for some time, and last week’s Consumer Price Index did not disappoint. Annual inflation fell to 0.1% – below our forecast of 0.2% and well below the Reserve Bank’s forecast (issued in December) of 0.4%. Falling petrol prices have obviously been the main contributor to low inflation. But that was anticipated. The real surprise was weak prices for many tradable goods other than petrol.

That is a crucial development in the debate around monetary policy. The Reserve Bank has been arguing that the lower exchange rate will push prices for tradable goods higher, causing inflation to rise above 1% by March 2016. We demurred, instead arguing that retailers have little scope to pass on price increases, that tight retail margins are the new normal, and that prices for tradable goods would remain subdued. The details of the CPI strongly favoured the latter view.

Lack of exchange rate passthrough, combined with plunging global oil prices, will make for another year of ultra-low inflation (oil prices fell as low as $26 per barrel last week). Our latest forecast sees inflation dropping to zero in September 2016, and remaining below 1% until 2017. There is a good chance that inflation will actually go negative at some point during the year.

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