KEY POINTS:
The monetary policy easing which is now officially under way is expected to work mainly through the exchange rate and the export sector.
Even though Reserve Bank governor Alan Bollard's decision yesterday to lower the official cash rate 25 basis point to 8 per cent was hardly a surprise - both economists and market pricing had rated it too close to call - the kiwi dollar dropped nearly 1c to US74.2c, 9 per cent below its peak five months ago.
Against the Australian dollar it is A77.5c, 13 per cent off its peak late last year.
"The strong interest rate advantage that has boosted the kiwi dollar continually to high levels over the past few years is going to be steadily eaten away over the coming 18 months," said Bank of New Zealand chief economist Tony Alexander.
While the Reserve Bank would continue to cut interest rates over the coming year, in the United States monetary policy was likely to be tightened, he said, and rate cuts were not expected to begin in Australia until April next year.
Economists expect to see a mirror image of the situation of the past few years when the Reserve Bank's tightening drove the exchange rate higher but had only an attenuated effect in the mortgage belt, as borrowers switched to fixed-rate loans and the risk premium in the cost of funds the banks raised overseas fell.
Now, with the credit crunch raising the risk premium to above-normal levels plus the lags implicit in fixed-rate lending, the effective or average mortgage rate is expected to go higher before it starts to come down.
First NZ Capital economist Jason Wong said the transmission of OCR cuts to the average mortgage rate borrowers face would be "incredibly slow".
"Relief for the real economy will be via the weaker New Zealand dollar," he said.
ANZ National Bank chief economist Cameron Bagrie believes the Reserve Bank will cut three more times by the end of the year, taking the OCR back to 7.25 per cent, and then pause until the middle of next year before taking it down to 6 per cent.
"The second leg of the easing cycle really requires commodity prices to fall. If they do we won't have as much inflationary impact from a lower dollar. One will offset the other," Bagrie said.
Westpac chief economist Brendan O'Donovan also expects the OCR to have fallen to 7.25 per cent by the end of the year as the Reserve Bank puts the priority on rescuing growth.
But the outlook beyond that was fraught with uncertainty, he said.
How would the exchange rate respond? Where would world oil prices go? Was the Reserve Bank right to think workers would struggle to get pay rises that compensated them for a higher cost of living, and that businesses would not be able to make price rises stick?
"These are huge questions and only time will tell," O'Donovan said.
Bollard's statement yesterday indicated the bank is expecting more inflation in the near term and weaker growth than it was six weeks ago.
Expectations for growth in New Zealand's trading partners have been revised down, oil prices have been higher than the bank expected, and continued turbulence in international credit markets has pushed up the risk premium New Zealand banks have to pay when raising funds offshore.
"It looks as if the bank has listened very carefully to the concerns we, and others, have been expressing about the impact of the credit crunch on lending rates," BNZ head of research Stephen Toplis said. The BNZ had been saying that the cash rate might have to fall at least 75 basis points simply to prevent lending rates from rising. "That's the last thing the economy needs right now."
Bollard gave two conditions for further OCR cuts, that the outlook for inflation continued to improve and that the dollar did not fall "excessively".
O'Donovan does not expect either condition to bite. The Reserve Bank thought about inflation primarily in terms of excess demand, he said, so it would trust the recession to bring inflation back into its target zone, ignoring the cost shocks the economy was facing.
"As for an 'excessive' fall in the currency, we suspect the bank has in mind something like early 2006 when the dollar plunged from US72c to US60c as the market anticipated rate cuts that ultimately weren't delivered. We view such a move as unlikely, given New Zealand's high [export] commodity prices."
Long hard grind
* The Reserve Bank expects economic activity to stay weak for the rest of this year and pick up only gradually next year.
* That will make it hard for firms to pass on costs or agree to higher wage claims, it says.
* Economists expect it to keep cutting the cash rate but warn it will take a long time for the domestic economy to feel the benefit.
