The Reserve Bank has driven the exchange rate down after it signalled a likely cut in the official cash rate next month and raised the possibility of another reduction further down the track.
While yesterday's action inspired just a half a US cent decline in the New Zealand dollar, the Reserve Bank's announcement this week of tighter loan-to-value ratio requirements, together with a lower-than-expected 0.4 per cent increase in the CPI for the June year, has helped drive the currency down by just over US2c.
The Reserve Bank is mandated to keep annual inflation within a 1 to 3 per cent range and very low inflation is seen as a risk to the economy as it gets close to deflation - when prices fall.
In an economic update, the Reserve Bank said prospects for growth in the global economy have diminished despite very stimulatory monetary policy and low oil prices and that significant downside risks remain.
It said the New Zealand dollar's trade-weighted exchange rate was 6 per cent higher than assumed in its June monetary policy statement and that the high exchange rate - which helps to depress prices - was making it difficult for the bank to meet its inflation objective.
"A decline in the exchange rate is needed," the bank said, adding monetary policy would continue to be accommodative. "At this stage it seems likely that further policy easing will be required to ensure that future average inflation settles near the middle of the target range," it said.
Economists now expect the Reserve Bank to cut its official cash rate - which stands at 2.25 per cent - by a quarter of a percentage point at its next opportunity on August 11, perhaps followed by another.
They have clearly attacked both [housing and the currency] at the same time and it remains to be seen as to the kind of success that they will have.
ANZ senior economist Philip Borkin said the strength of the New Zealand dollar was making it difficult for the bank to meet its 1 to 3 per cent inflation mandate.
Borkin said the Reserve Bank's announcements over the past week, coupled with the low CPI outcome, had confirmed the currency market's assumptions.
He said the bank faced a juggling act between not wanting to stimulate more activity, through low interest rates, in an already hot property market, while trying to engineer a lower exchange rate. "You have got the housing market on one side and the currency on the other," Borkin said. "They have clearly attacked both at the same time and it remains to be seen as to the kind of success that they will have."
On the currency side, the Reserve Bank is swimming against the tide. Even at just 2 per cent, the official cash rate is still higher than the official rate of many other developed economies, which has meant the currency has remained well-sought on an interest rate differential basis.
"For the time being, the Reserve Bank will probably be happy with the movements that it has generated, but there is still a lot of water to flow under the bridge," Borkin said.
ASB economists said the statement reinforced their view that the Reserve Bank would cut the official rate to 2 per cent in August and then to 1.75 per cent in November.
"This week's proposed tightening of loan-to-value restrictions helps them on this front," ASB said.
Westpac economists said the strong dollar was undermining the outlook for inflation. "We have maintained the view that the official cash rate could be cut to 2 per cent in August, and today's statement seals the case," Westpac said.
The dollar was trading at US69.80c yesterday afternoon, down from US70.30c just before the announcement, and US73c last week.
• Reserve Bank mandated to keep inflation in 1-3% range.
• High exchange rate helps to depress prices.
• Central bank signals cut to official cash rate next month.
• Tighter loan-to-value ratio rules for mortgage lending.