More cuts – but when?

The Reserve Bank’s September Monetary Policy Statement offered few surprises. We continue to expect the OCR to fall all the way to 2%, though the timing of the Reserve Bank’s next move is uncertain.

As expected, the Reserve Bank lowered the OCR by another 25 basis points to 2.75%, and signalled that one more rate cut is likely, depending on the economic data. Interest rates accordingly fell only slightly. The New Zealand dollar fell surprisingly sharply, but this came after equally unexplained gains over the previous few days.

What will the Reserve Bank do next? After perusing the Reserve Bank’s forecasts, we continue to expect that the OCR will end up lower than the Reserve Bank is currently signalling. Our disagreement isn’t on the outlook for economic growth - the Reserve Bank now broadly shares our view that a significant economic slowdown is coming – but on what this will mean for inflation. The Reserve Bank is pinning a lot of hope on the idea that the lower NZ dollar will cause a sustained lift in imported inflation, and that this will be enough to get overall inflation comfortably back to 2% even as the economy slows.

We aren’t so sure. There’s no question that the lower exchange rate will cause a temporary burst in inflation as prices of tradable goods and services rise. But we see no real reason why a lower exchange rate should cause a long-lasting lift in the rate of change of consumer prices, as the Reserve Bank is assuming. Moreover, the amount of tradable inflation that the Reserve Bank expects – more than 3% by the end of next year – seems very high. Outside of GST increases and spikes in global oil prices, tradable inflation has rarely exceeded 3% a year. The only time it has been at these levels for a significant length of time was in 2000-01, after the exchange rate had fallen to a record low and oil prices had tripled over the previous three years, from $10 to $30 a barrel.