The Economy Hub: Reserve Bank surprises, cuts rates to 2.25pc

• The cut of 25 basis points was unexpected and bring rates to a new record low of 2.25 per cent.

• The Co-Operative Bank was the first bank to drop its floating mortgage rate, saying it wanted its customers to quickly receive the benefits of the cut.

• Governor Graeme Wheeler said cheap fuel and other imports continued to keep inflation low and he didn't expect inflation to reach the targeted mid-point of 2 per cent until March 2018.

• Wheeler warned if the OCR cut put more heat into the housing market the Reserve Bank would have to consider raising rates.

Reserve Bank Governor Graeme Wheeler's rate cut today has surprised markets and increased the chance that we could see rates go below 2 per cent for the first time, says Paul Dales, chief economist at Capital Economist in Sydney.

That would require two further cuts to the rate. Most economists are picking just one.

Today Wheeler cut the benchmark rate 25 basis points to a record low 2.25 percent and lowered the forecast track to the 90-day bank bill rate, often seen as a proxy for the OCR, by half a percentage point over the next two years, implying another reduction is still to come.

The kiwi dollar tumbled after the unexpected move.

Economist Dales was one of the few talking up the chances of cut today and he now says "there is a real possibility" we will see rates fall below 2 per cent.

"The RBNZ has clearly been spooked by the recent weakening in the outlook for the global economy, the strengthening in the New Zealand dollar and the fall in domestic inflation expectations," he says.

ASB chief economist Nick Tuffley said Wheeler deserved a bouquet for cutting today. " It was a prudent decision given the looming risks of inflation remaining stubbornly low."
The window for another cut in April was now live, he said.

However Tuffley said the RBNZ also deserved a brickbat for "the extent of its U-turn relative to the speech made on February 3rd."

In that speech the Governor had implied that people forecasting OCR cuts were responding mechanistically to low headline inflation and he heavily emphasised the flexibility of the inflation target, Tuffley said.

"In the 5 weeks since then, the only material shift has been the various inflation expectations measures. The tone of that speech suggested the RBNZ was a long way from contemplating an OCR cut, and will have contributed to the extent of market surprise today."

The Co-operative Bank has become the first bank to cut its mortgage rates after this morning's Reserve Bank move.

It has cut its floating mortgage rate from 5.7 to 5.45 per cent but its fixed mortgage rates remain the same.

Chief executive Bruce McLachlan said the decision to drop the OCR was unexpected but the bank felt it was important to pass this change on to its customers so that they could quickly receive the benefits.

The surprise cut is likely to send all the floating rates at the banks downwards by 0.25 basis points but each bank will be weighing up whether to also cut its fixed rates.

Fixed rates are heavily influenced by what the bank pays to borrow money in the international market and may not change at all despite the cut.

Fixed rates are much lower than floating rates and many people have been fixing their mortgages in recent months to take advantage of record low fixed terms for their home loans.

"Headline inflation is expected to move higher over 2016, but take longer to reach the target range," Wheeler said. "Further policy easing may be required to ensure that future average inflation settles near the middle of the target range."

A rebound in the New Zealand dollar from its trough in September was feeding into the weak inflation outlook, making imports cheaper and its resilience has been a persistent thorn in the

Reserve Bank's side by sapping inflation in tradeable goods and services. The trade-weighted index was 4 percent higher than the bank's December projection and Wheeler said "a decline would be appropriate given the weakness in export prices."

The New Zealand dollar dropped to 66.63 US cents from 67.77 cents immediately before the statement. The trade-weighted index fell to 71.53 from 72.70.

The global slump in oil prices, heightened market volatility in financial markets, and the extension of extraordinary monetary policy by some central banks to introduce negative interest rates stoked expectations NZ's Reserve Bank would have to lower the OCR.

Wheeler said cheap fuel and other imports continued to weigh on headline inflation, which has been below the central bank's target band of 1-to-3 percent since September 2014.

Stripping out "transitory price movements" annual core inflation was at 1.6 percent.

The Reserve Bank doesn't expect the CPI to get back within the band until the December quarter this year, and anticipates it won't be at Wheeler's targeted mid-point of 2 percent until March 2018.

Two key risks that could prompt even lower interest rates were if imported inflation was lower for longer than the central bank's projections, and also if global investors lost their appetite for risk-sensitive assets, which would push up local banks' funding costs and likely lead to higher mortgage rates.

Conversely, if the current level of the OCR stokes a resumption of rapid house price appreciation and domestic consumption that would need rates to rise.

The Reserve Bank expects gross domestic product will continue to grow at largely the same pace over the forecast horizon as strong tourism, a building pipeline of construction work, and low interest rates stoke activity.

Read the full Monetary Policy Statement here