How low can you go?

The challenges facing the New Zealand economy have continued to mount, prompting us to change our expectations for rate cuts from the RBNZ. We now expect the RBNZ to cut the OCR to a record low of 2.0% by the end of this year. This will involve one reduction of 50bp - most likely in September, but possibly as early as this week’s July OCR Review. We expect 25bp reductions in the OCR at each of the other three meetings this year.

In recent weeks we’ve noted the increasing signs that the economy is losing momentum, including sharp declines in household and business confidence. On top of those earlier developments, there have been two major developments over the past week that have prompted us to change our OCR call.

The first is the continued sharp decline in global dairy prices. Prices were down 10.7% in the latest GlobalDairyTrade auction, taking them to their lowest level in six years. There were large declines for almost every product, and that downward pressure is likely to spill over into the next auction in early August. We’ve made a significant downward revision to our forecast for Fonterra’s milk price for the current season. We now anticipate a payout of $4.30/kg, which would be even lower than last season’s already very weak outcome. This means export earnings will be around $2 billion lower than we had expected.

Two very low payout years in a row signals tough times ahead for many in the dairying sector. But the impact of lower prices will also be felt more widely in the economy. Household and investment spending in rural communities can be expected to drop back. In addition, it’s inevitable that challenging conditions in the rural sector will pass through to lower confidence in the economy more generally. This signals downside risk for businesses’ investment and hiring decisions over the coming year.