KEY POINTS:
Caught between a devil of a slowdown and the deep blue sea of near-term inflation, the Reserve Bank has taken the plunge and signalled a start to its easing cycle in September, a year earlier than it foreshadowed only three months ago.
The Reserve Bank yesterday left the
official cash rate at 8.25 per cent but delivered a strong message on the state of the economy.
There was nothing coy or coded about what it said: "Provided the economy evolves in line with our projection we are likely to be in a position to lower the [official cash rate] later this year."
Lest there be any doubt, Governor Alan Bollard told MPs on the finance and expenditure select committee that the bank had put out a softer track than the financial market had already priced into wholesale interest rates.
The market's reaction was to sell the New Zealand dollar - by more than a cent against the US dollar - and to push rates in the swaps market down 20 basis points at the two-year point of the curve. Some banks have already lowered mortgage rates in response.
The Reserve Bank is taking a much bleaker view of growth and inflation than in the March monetary policy statement.
Household spending is expected to be feeble over the next three years, as are business investment and residential construction.
But inflation is projected to hit 4.7 per cent by September and not fall back within the bank's target band until 2010.
"Oil prices are up 20 per cent since March and food prices have also had a very big increase, comparable to the 1970s," Bollard said.
He rejected talk of a return to 1970s-style stagflation, however. The combination of feeble growth and high inflation would be more transitory, reflecting a fundamentally more flexible and better managed economy.
The weaker growth outlook, especially for household consumption, reflects a more negative view of the housing market, which is expected to drop 13 per cent from its peak last year in nominal terms and 22 per cent in real terms over three years.
Unemployment is expected to rise from 3.6 per cent now to 6 per cent by 2011.
"They are right to conclude that the pressures on the domestic economy are strong enough that it should mean a sharp drop in inflation pressure over the medium term," Bank of New Zealand economist Stephen Toplis said.
"For them to ignore the domestic economy would be nothing short of negligent. And remember that their growth outlook is predicated on their interest rates forecast - imagine what it would look like without those rate cuts and a substantial fall in the currency."
But Westpac chief economist Brendan O'Donovan believes the bank is being much too pessimistic about growth, and taking risks with inflation expectations.
"Assuming population growth of around 1 per cent a year, the Reserve Bank is expecting three years of deep per capita recession in the consumer sector. This at a time of a terms of trade boom and the biggest fiscal stimulus in 10 years."
The bank assumes inflation expectations, which have been slowly rising since the turn of the century, will "remain anchored".
This was not credible, O'Donovan said, when the central bank itself was forecasting inflation to average 3.4 per cent over the next three years (even with the fall the bank continues to project - despite repeated disappointment - in oil prices).
"They are assuming that even if workers would like compensation for sharp cost of living increases, employers will be in no position to deliver it and hence the economy will not go into a 1970s-style wage-cost push spiral. We hope they're right but we are not convinced."
It was no use Bollard saying that excluding food and energy inflation was within the target band; consumers could not exclude those things, O'Donovan said.
By issuing so dovish a statement the bank was undermining one of the supports of the currency.
"If the dollar drops 10 per cent inflation will be 1 per cent higher. That's $1 billion worth of real wage cuts. They would be saying: You are feeling the pressure from high inflation? Well, here's some more."
BIG CHANGES
Reserve Bank predictions:
* Interest rates and the dollar fall.
* But growth slows to 0.9 per cent over the year to March 2009. A technical recession is not forecast but cannot be ruled out.
* Inflation hits 4.7 per cent by September and averages 4.1 per cent through the first half of next year. The bank hopes employers and workers will look forwards, not backwards, in pay negotiations.
* Employment shrinks and the unemployment rate rises to 6 per cent by 2011.
