KEY POINTS:
Five years after he last cut the Official Cash Rate (OCR), Reserve Bank Governor Alan Bollard is poised to start a new easing cycle, but whether he begins next Thursday or waits until September is too close to call.
Forced to pick a date, the majority of market economists say he will wait until the next full monetary policy statement on September 11, by which time he will have fresh data on the state of the labour market.
But they still put the probability of a move this week at 40 per cent while market pricing, as reflected in Credit Suisse's swaps-based indicator, implies a 56 per cent chance.
A key uncertainty is the outlook of international oil prices. Even with the most recent falls they are some 15 per cent higher than the Reserve Bank assumed they would be - repeating the pattern of over-optimistic forecasts evident for several years now.
In the June quarter higher petrol and diesel prices accounted directly for half of the 1.6 per cent jump in the consumers price index (CPI). Higher food prices, also underpinned by a global commodity boom, accounted for another quarter.
While these price shocks push up inflation in the near term, they have the opposite effect in the medium term.
By crowding out spending on other things, they slow the economy and make it harder for firms to pass on their increased costs. In the case of oil in particular, most of the extra money motorists and truckers pay at the pumps just leaves the country.
But the danger is that the near-term jump in inflation drives already elevated inflation expectations higher still, and becomes embedded through a wage-price spiral.
The bank's June statement, in which it said it was "likely to be in a position to lower the OCR later this year", came with clear caveats: "Our projections assume that inflation expectations have peaked and will not move much higher in response to the temporary near-term spike in annual inflation we are projecting."
Bank of New Zealand economist Stephen Toplis said business survey data indicated the labour market had eased. "And the anecdotal evidence would have you believe a big-shake-up is coming."
But the Reserve Bank probably needed to see the wage and jobs data due in the first week of August before drawing too many conclusions about the labour market, Toplis said.
The other key assumption behind the Reserve Bank's easing bias is that weakening economic activity will curb domestic or non-tradeable inflation.
The June CPI showed non-tradeable assumption at 0.9 per cent in the quarter to March - marginally lower than the bank had forecast, but still high.
ASB chief economist Nick Tuffley said the case for a July rate cut could be summed up in one word: recession.
Firms' views of their own outlook, as captured by the New Zealand Institute of Economic Research quarterly survey of business opinion, are back at levels last seen in the recession of early 1990s.
And the recent troubles of Fannie Mae and Freddie Mac in the United States showed the world economy was far from out of the woods of the credit crunch.
"Increased risk aversion has the potential to reduce the potency of OCR cuts," Tuffley said.
Given that, and the long lags with which monetary policy works, monetary conditions would still be very tight even if the bank cut the OCR two or three times by the end of the year.
"Wait too long and the Reserve Bank risks making the recession worse," Tuffley said.
He expects the bank to take a softly, softly approach to easing.
"They will want to see the effect of a modest easing on the housing market, via mortgage approvals, house sales and lending growth to get a feel for how potent their cuts are."
The financial markets are pricing in five rate cuts by March next year. Toplis believes that is more aggressive than the bank would be comfortable with.
That would cut the cash rate to 7 per cent and with inflation expectations around 3 per cent it would mean a real interest rate of 4 per cent.
"That's roughly neutral and would be inconsistent with its stated view that 'interest rates are likely to remain well above neutral for some time, until we are more confident that medium-term inflation pressures are easing'."
TOSS OF THE COIN
* With the economy almost certainly in recession the Reserve Bank needs to cut its cash rate.
* But it also needs to be confident the latest surge in inflation will not become self-perpetuating through a wage-price spiral.
* The markets believe it will see recession as the bigger threat.
* But whether it starts to cut next week or in September is a coin toss.
