Official Cash Rate: Could the Reserve Bank lower interest rates more if we were more productive? – Jenée Tibshraeny

An economist has challenged Reserve Bank governor Adrian Orr's view an OCR of between 2.5% and 3.5% would be "neutral". Photo / Mark Mitchell

THREE KEY FACTS

• The Reserve Bank cut the OCR by 50 basis points to 4.25% last week.
• It revised down its “potential output” forecast, suggesting the economy can sustain less activity than previously thought without this affecting inflation.
• Economic experts say this shows there are limits to the amount the Reserve Bank can cut the OCR by.

There is only so much low interest rates can do to fire up the economy.

With the Covid-era runaway house price spike etched in many of our minds, it’s reasonable to be wary of not leaning too heavily on cheap debt to pump up the economy.

But here’s the thing: we might not be able to, even if we wanted to.

This was an underlying message in the Reserve Bank’s (RBNZ) quarterly Monetary Policy Statement, released last week.

Fairly major revisions to its forecasts suggest it has less room than it previously thought to lower interest rates without igniting inflation.

Or, to use Westpac chief economist Kelly Eckhold’s analogy, the RBNZ believes the speed limit for the economy is lower than previously thought.

Why does this matter? It puts the onus on Government policymaking and business investment decisions to improve growth. The RBNZ isn’t there to save the day – alone.

Let’s go back a step. Where does this thesis come from?

The RBNZ has materially revised down its potential output forecasts since August.

It believes the level of activity the economy can sustain without this affecting inflation is lower than previously thought.

Why? It has changed its modelling.

The RBNZ now believes population changes have a greater impact on potential output than previously assumed. Because fewer migrants are moving to New Zealand than the RBNZ expected in August, it has downgraded its forecast of New Zealand’s potential output.

For example, it now sees potential output increasing by 1.7% in 2025, rather than the 2.4% forecast in August. By 2026, it sees this growth slipping to 1.5%, down from 2.3%.

It basically believes New Zealand’s waning productivity growth means it’s less able to absorb stimulus, without this being inflationary.

JB Drax Honore chief strategist for Asia-Pacific, Sean Keane, believes the situation makes for a “very challenging macro-economic outlook”.

Keane reckons the RBNZ’s recalculation of potential output would have “removed any talk of faster easing”, or more rapid Official Cash Rate (OCR) cuts.

While some market participants (particularly those overseas) believed the RBNZ’s Monetary Policy Committee could’ve cut the OCR by a big 75 basis points last week, governor Adrian Orr was categoric when he said the committee didn’t consider this, and was firm in its view that reducing the OCR by 50 points to 4.25% was sufficient.

He also underlined the fact the committee had pencilled in another 50-point cut for its next meeting on February 19.

Thereafter, the pace of OCR cuts is expected to slow until the OCR gets to around 3.5% by the end of 2025 and 3.25% by the end of 2026. Again – these are all forecasts, up for revision.

Orr said the RBNZ believed an OCR of between 2.5% and 3.5% was considered “neutral” – neither stimulatory nor contractionary.

But Eckhold, of Westpac, believed an OCR of 2.5% would be stimulatory, and the neutral rate was actually closer to 4%.

So, he believed the OCR would settle at a slightly higher level than would be the case if the economy were more productive and better able to absorb stimulus.

He described an economy with limited output potential to that of a narrow pipe. If you blast a whole lot of water through it, it breaks. But if you have a wider pipe, the water flows though.

All this amounts to there being less room – in Eckhold and Keane’s views – for New Zealand to rely on low interest rates to drive growth.

The pressure is really on the Government, rather than the RBNZ, to ensure its policies improve productivity.

There is widespread political recognition of the need for improved productivity, but the solutions are multi-pronged and might not get politicians the quick wins they’re after as they work to three-year governing cycles.

Jenée Tibshraeny is the Herald’s Wellington business editor, based in the Parliamentary press gallery. She specialises in Government and Reserve Bank policymaking, economics and banking.