Markets forecast cash rate cut

Reserve Bank Governor Graeme Wheeler. Photo / Mark Mitchell

Falling dairy prices, weak inflationary pressures suggest further reductions on cards.

The markets regard it as virtually certain the Reserve Bank will cut the official cash rate from 3.25 to 3 per cent on Thursday and they will focus instead on what the accompanying comments signal about how much further the bank might yet go.

In Reuters' latest survey of market economists a rate cut this week is seen as a done deal and virtually all expect governor Graeme Wheeler to cut the OCR again, to 2.75 per cent by the end of September. Indeed some see a decent chance of a 50 basis points cut.

A majority expect an OCR of 2.5 per cent by March next year, fully reversing last year's hikes.

Money market pricing implies a better-than-even chance of a fourth cut by the end of this year.

This reflects a combination of falling export dairy prices, feeble inflationary pressures and a deterioration of business and consumer confidence.

After rebounding early in the year, export dairy prices have fallen 38 per cent over the past four months, including a lurch lower of nearly 11 per cent in last week's auction.

This has been partially offset by a lower exchange rate. The New Zealand dollar has fallen 13 per cent on a trade-weighted basis over the past four months, and 14.5 per cent against the US dollar. This is helpful for exporters.

But the prospect of a second successive season of a low dairy payout has hit business and consumer sentiment, which are at multi-year lows, implying a reduced willingness for households to spend and for businesses to invest and hire.

In addition, last week's June quarter inflation data recorded the lowest rate of non-tradeables or domestic inflation (the 56 per cent of the consumers price index unaffected by world prices or exchange rates) for 14 years.

"Given that the economy has only started to weaken the question is how low could core inflation get if the significant slowdown that we expect takes hold?" Capital Economics' chief Australia and New Zealand economist Paul Dales said.

A lower exchange rate will push up tradeables prices with a lag but how strong that effect is, as opposed to the hit to margins, will depend on retailers' pricing power.

When market conditions are highly competitive, income growth subdued and consumer sentiment soft, the pass-through from a lower kiwi dollar may be slower and weaker than a Reserve Bank trying to push inflation back up towards its 2 per cent target midpoint would like.

Westpac's chief economist, Dominick Stephens, is forecasting an OCR of 2 per cent (a record low) by the end of the year. So does Dales.

Stephens argues that the two big factors which have accounted for New Zealand interest rates being so much higher than prevailing global ones - the most favourable terms of trade for 40 years and the huge demand pulse from the need to rebuild Christchurch - no longer hold good.

Tumbling dairy prices have put paid to the former and Westpac believes we are just about at the peak of the rebuild and after a year-long plateau it will start subtracting from growth, not adding to it.

"In addition we have crossed the Rubicon in terms of confidence. It turned on a dime and that will affect investment and employment," Stephens said.