Time to sharpen the clippers?

Columnist·NZ Herald·

4 Jun, 2015 05:00 PM6 mins to read

To cut or not to cut? Illustration / Anna Crichton

Economists divided on whether now is the moment to cut interest rates.

To cut or not to cut?

That is the question the Reserve Bank confronts ahead of next week's official cash rate decision. The answer, on the balance of probabilities, is not just yet.

The case for an immediate cut, advocated by ANZ chief economist Cameron Bagrie, goes like this.

When the Reserve Bank is doing monetary policy, its target is consumer price inflation, not economic growth or the state of the housing market. And while growth has been running at a rate which traditionally would have been an open invitation to mounting pressure on prices, inflation has not shown up at the party.

Much of that is because there is a lot of excess capacity in the world economy and extraordinarily loose global monetary conditions, one of whose side-effects has been to keep the New Zealand dollar uncomfortably high. But those factors do not entirely explain the weakness of inflation, the bank thinks, suggesting some domestic structural factor is at work too.

Whatever.

A strategy of waiting to see if inflation does show up, albeit late, and keeping the OCR on hold in the meantime is risky, Bagrie argues, given how low inflation is.

"What happens if the non-OCR measures to cool the Auckland housing market work, which we think they will? Where could inflation be if you take out Christchurch - the fading rebuild stimulus - and Auckland housing, and add in the dairy income hit?"

Given the lags with which interest rate changes affect activity and prices, the Reserve Bank needs to be ahead of the curve, Bagrie says.

Deutsche Bank chief economist Darren Gibbs also believes the Reserve Bank will cut the OCR next week and again next month, pushed over the line by greater-than-expected slack in the labour market. The unemployment rate is 5.8 per cent, where the RBNZ forecast 5.5 per cent.

Westpac's chief economist, Dominick Stephens, on the other hand, says an OCR cut next week is unlikely because the conditions the bank has put around a cut have not been satisfied.

In April bank Governor Graeme Wheeler said, "It would be appropriate to lower the OCR if demand weakens, and wage- and price-setting outcomes settle at levels lower than is consistent with the inflation target." But has demand growth actually slackened?

Not if you look at retail sales, up a hefty 2.7 per cent in real terms in the first three months of the year.

Not if you look at the labour market. Households' collective wage and salary income grew 6 per cent in the year to March, underpinned by strong employment growth, in a year when inflation was just 0.1 per cent.

Not if you look at population growth, boosted by a strong net inflow of migrants, adding 56,000 to the population in the year ended April.

That is stoking demand for housing in Auckland, and a key area of uncertainty for the central bank is how much impact its move to make it harder for investors in the Auckland market to obtain credit, combined with the Government's tax moves targeting speculators, will have.

It would be wrong for the Reserve Bank to commit to OCR cuts on the assumption that these policies will work as intended, Stephens argues: "The recent house price surge is too powerful and too poorly understood for that, not to mention that the policies themselves are untried. Instead, the Reserve Bank will probably want to actually observe the housing market cooling before it commits to reducing the OCR."

What about Wheeler's second condition - that wage- and price-setting outcomes settle at levels lower than is consistent with the bank's inflation target, whose mid-point is 2 per cent?

Wage inflation is running between 1.7 and 2.1 per cent, depending on which measure you use, and the Reserve Bank's own survey found the inflation expectation two years ahead is 1.85 per cent.

The key word in this condition is "settle", Stephens argues. "It is not possible to suggest that wage- and price-setting behaviour has settled below the target, given that most of these measures took a step down only very recently, and could pop higher again when the recent fall in petrol prices drops out of annual inflation calculations next year."

He also points to the central bank's track record of preceding any series of rate hikes or cuts by a clear and unequivocal warning, using words like "likely" and "expects", and publishing forecasts which include a rising or falling track for 90-day interest rates, as the case may be. It has not done that yet.

The Bank of New Zealand's head of research, Stephen Toplis, sees interest rate cuts by the end of the year as a real possibility but sees no justification for going this month. Domestic demand is just too strong and wage- and price-setting behaviour not weak enough.

"The problem that the Reserve Bank faces is that if it doesn't cut, the New Zealand dollar might spike higher," Toplis says.

But the bank should not feel bullied into action by this threat, he says. Better to let the currency do what it is going to do and then respond to it, later, if necessary.

The kiwi has been trading lower than where the Reserve Bank assumed it would on a trade-weighted basis. "This gives the bank some flexibility in entertaining the possibility of a bounce."

Three factors which could trigger a rate cut as early as September in Toplis' view are if the kiwi forges higher, or if it becomes increasingly clear that next year's dairy payout will be as low as this year's, or if the June quarter's labour market data show rising unemployment and a further reduction in wage growth.

To that list you might add international risks like the Chinese economy coming unstuck or the US Federal Reserve failing to start raising interest rates.

But such a possibility argues for a later start to an easing cycle in New Zealand, Toplis contends, on the grounds that it would leave the bank with more scope to cut rates then.