Former Economics Editor of the NZ Herald

Brian Fallow: Cash rate cut defies reality

Little NZ can do about high dollar or inflation.
Economic growth - north of 3 per cent this year and next year, the bank reckons - is strong by the standards of developed countries these days. Illustration / Anna Crichton (illustrator@annacrichton.com)
Economic growth - north of 3 per cent this year and next year, the bank reckons - is strong by the standards of developed countries these days. Illustration / Anna Crichton (illustrator@annacrichton.com)

Inflation is too low and the kiwi dollar is too high.

Those are the reasons offered for the Reserve Bank cutting the official cash rate yesterday and foreshadowing more easing to come.

Neither is convincing.

Not because they are not true, but because there is little the bank can do about either at this juncture.

As far as exchange rates go, it takes two to tango and New Zealand generally does not get to lead in that dance.

Three weeks ago, when the Reserve Bank signalled the OCR cut it has now delivered, it pushed the kiwi back below US70c - for all of four days. Since then it has bobbed around in response to whatever the latest data from the United States suggested about when the Federal Reserve will start to tighten.

As usual, the bank's forecasts assume the exchange rate will decline, gradually, from here.

But it acknowledges the risk that it will not, in which case "additional monetary stimulus would be required to offset the dampening impact on inflation." Governor Graeme Wheeler acknowledged yesterday that the bank does not have a lot of influence on the exchange rate.

But in a world where many of his peers are still easing monetary policy, the risk is that widening interest rate differentials will put further upward pressure on the exchange rate, keeping tradables inflation negative, headline inflation low and heightening the risk of a self-fulfilling decline in inflation expectations.

The exchange rate is not just driven by interest rate differentials, however, and that is just as well. Our abject reliance on importing foreigners' savings means we are in no position to take part in a race to the bottom in interest rates.

There are some fundamental factors supporting the New Zealand dollar as well.

Economic growth - north of 3 per cent this year and next year, the bank reckons - is strong by the standards of developed countries these days.

And while the slump in dairy prices deservedly gets a lot of attention, New Zealand is not just one big dairy farm.

The terms of trade reflect relative prices for the kinds of things we export as against the kinds of thing we import - the international purchasing power of a standard basket of exports. They have declined nearly 6 per cent over the past couple of years.

But that was from a 40-year high. The terms of trade are still more favourable than they have been for all but three of the past 60 years.

The most recent read we have for the terms of trade is for the March quarter. Since then export prices, as reflected in ANZ's commodity price index, have risen. On the import side, oil prices tried to rally but slumped back down again.

A high exchange rate is not the only, or even the main, reason tradables inflation has been in deflationary territory for the past four years. The bank forecasts it to remain negative for another year.

Across the OECD, the annual inflation rate is 0.8 per cent, despite extraordinarily loose monetary policy. That testifies to some powerful disinflationary forces at work in the global economy: industrial overcapacity, a down phase in the commodity super-cycle and perhaps structural factors to do with demographics and technology.

It is facile to assume the Reserve Bank can entirely compensate, in some seesaw fashion, for a high dollar or feeble global inflation by simply cutting the official cash rate.

As the cliche has it, it is pushing on a piece of string.

When economic output is expanding at around 3.4 per cent and interest rates are already at multi-decade lows, it is not obvious that what ails the economy is deficient domestic demand and the prescription is lower interest rates.

What will yesterday's OCR cut do to stimulate household consumption?

The first question is how much of it will the banks pass on to retail mortgage and deposit rates?

As far as exchange rates go, it takes two to tango and New Zealand generally does not get to lead in that dance.

Wheeler said he would like to see most of the OCR cut passed on but banks would have to make their own commercial judgments about competitive pressure, interest margins and funding costs.

Suppose people with a floating rate mortgage do get a boost to their discretionary spending power from the OCR cut.

Some may thankfully go out and spend it, especially if their debt servicing ratio is high.

But this week's electronic card transactions data indicate retail spending is pretty brisk already, up 5.8 per cent on July last year or 8.3 per cent when gas stations are excluded.

The bank acknowledges that the wealth effect, where homeowners spend a few cents in the dollar of the increase in their housing equity, has proven weaker than usual in this cycle.

And some households have opted to take advantage of low interest rates to accelerate the repayment of their home loans.

Reserve Bank data split repayments (other than repayments in full when a mortgaged property is sold) into scheduled and excess repayments. For the past three quarters, a majority of repayments have been excess rather than scheduled, indicating that many people have prioritised paying down their loans.

So not much stimulus there.

And is it plausible to think a lot of businesses have been holding back on some expansion because the cost of credit is too high?

On the other side of the banks' ledger, lower deposit rates would be unwelcome for those older folk for whom that is an important income stream. They are liable to respond to lower interest rates by tightening their belts.

While it is debatable how much good increasing the dosage of monetary stimulus will do, there is not much doubt about the negative side-effects in terms of stoking house price inflation.

Which presents the greater risk: stubbornly low consumer price inflation or rampant house price inflation? Clearly the latter.

- NZ Herald

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