The Reserve Bank is expected to keep its official cash rate unchanged at 3.5 per cent on Thursday but in the accompanying statement to shift the guidance needle slightly to the easier side of neutral.
Although it said last month the next move in interest rates could be either up or down, assistant governor John McDermott last week indicated the hurdle to an OCR hike is high but "evidence of weakening demand and domestic inflation pressures would prompt us to consider lowering interest rates".
Money market pricing implies around 25 basis points of OCR cuts over the coming year.
Westpac chief economist Dominick Stephens sees a 40 per cent chance the Reserve Bank will cut the OCR to 3 per cent before the year is out.
"Monetary policy has been stuck between a rock and a hard place for some time. Near-zero inflation, dimming prospects for primary exporters, and an extremely high trade-weighted exchange rate all argue for OCR cuts," he said. "But cutting the OCR would risk turbo-charging the already-hot domestic economy, thus generating a future inflation issue. Auckland house prices are roaring higher, construction activity is booming, net immigration is running at all-time highs, and consumers are on a spending spree."
The Reserve Bank also cannot ignore an international environment where many central banks are cutting interest rates or printing money.
ANZ chief economist Cameron Bagrie said: "The Reserve Bank is looking increasingly out of step with its peers, when one views inflation rates versus policy rates. The former is low [0.1 per cent] and the latter is high [3.5 per cent]. And this creates collateral damage via the currency."
The Kiwi dollar has been running about 3 per cent higher on a trade-weighted basis than the Reserve Bank's March forecasts assumed, despite falling export dairy prices.
Bagrie said the failure of dairy prices to recover meaningfully was increasing the very real prospects of a second consecutive low payout in the 2015/16 season. And the Reserve Bank's forecasters are still estimating the impact of the summer's drought on output and incomes.
The net inflow of migrants continues to strengthen, with a net gain of 56,300 in the year ended March. The Real Estate Institute reports the median house price in Auckland rose 13 per cent to $720,000 in the year ended March while its stratified index, which adjusts for variations in the mix of properties sold which can affect the median, was up 20 per cent in the city and nearly 10 per cent nationwide.
The Reserve Bank has indicated that it will restrict mortgage lending to landlords. However, implementing such restrictions is infeasible until later in the year.
ASB chief economist Nick Tuffley does not think the housing market would stand in the way of an OCR cut if the inflation outlook warranted further stimulus.
"But there would be some gritting of teeth as a lower OCR would increase the Reserve Bank's concerns about financial stability."
Stephens said macro-prudential tightening - regulatory intervention to curb the volume of lending into the housing market, like the LVR limits - was one possible way the bank could resolve its conundrum.
"The Reserve Bank has indicated that it will restrict mortgage lending to landlords," he said. "However, implementing such restrictions is infeasible until later in the year. The Reserve Bank may be loath to cut the OCR until it is comfortable that the housing market can be contained another way."
McDermott last week reiterated the bank's concern was that low headline inflation, while temporary, could start to influence inflation expectations and, in turn, wage- and price-setting behaviour in a way that would make it increasingly hard to get inflation back towards its 2 per cent target mid-point.
On that front, Tuffley said, it was still much too early to tell.
"Changed behaviour ... could prompt further action later in the year. "