Liam Dann: Confused about where rates are going? You should be

The official cash rate is likely to stay on hold at 2.5 per cent when Reserve Bank Governor Graeme Wheeler delivers his first full monetary policy statement of the year. Photo / Mark Mitchell

The official cash rate is likely to stay on hold at 2.5 per cent when Reserve Bank Governor Graeme Wheeler delivers his first full monetary policy statement of the year on Thursday.

Sounds simple enough. But beneath the surface of stability lurks one of the most complicated and contentious monetary policy environments in recent years.

Here's a snap synopsis of current market thinking: the governor doesn't want to cut rates, but he will have to cut because the world's so gloomy, possibly twice, but not next week, unless he decides to surprise everyone, which he might because he does that sort of thing sometimes.

Confused? You should be.

There is an increasingly intense debate going on about the effectiveness of conventional monetary policy in the current deflationary global economic environment. In Europe and Japan rates have been cut below zero, which is - in non-technical terms - doing everyone's head in.

A lot of the debate in this country has centred on whether the current lack of inflation is structural or cyclical.

Some commentators have suggested the Reserve Bank is out of touch. The governor pushed back in January with a speech that urged people to look through the weird stuff like collapsing oil prices and focus on core inflation.

The Reserve Bank is mandated to target an inflation mid-point of 2 per cent but last year it ran at just 0.1 per cent. And we actually had deflation of 0.5 per cent for the fourth quarter.

It has become such a hot topic in Wellington that Finance Minister Bill English had to make it clear on Friday that the Government wasn't about to intervene and review Reserve Bank policy mid-term. English said he was happy to wait until the next official review in September next year. These were unusual times and we'd have a clearer view of real inflation by then, he said.

In Europe and Japan rates have been cut below zero, which is - in non-technical terms - doing everyone's head in.

The fact that he had to comment at all is an indication of how unusual the inflation situation has become.

Meanwhile in Auckland, where deflation just means cheaper bathroom fittings and all we talk about is house prices, the debate is raging as to whether recent falls in the property market will continue or whether it has just paused. The bank is highly attuned to the risk of a house price crash which would devastate the economy. There is evidence that prices are in bubble territory in Auckland and further rate cuts might fuel that.

The Economy Hub: OCR Preview

Even this theory is now complicated by global financial market turmoil which has pushed up credit risk in the banking sector and is lifting the cost of international borrowing for local banks. As a consequence ANZ's economists are emphasising the risk that mortgage rates could actually rise if the OCR is left unchanged.

Local banks still rely on international sources for 25-30 per cent of their funding, despite a shift in balance towards local funding after the global financial crisis.

Higher mortgage rates wouldn't bother the Reserve Bank but if the market turmoil flows through to lower global growth then it will find itself back looking at the case for cutting further.

Out in the regions, where conversation tends to stay focused on the productive end of the economy, there is serious concern about farm debt levels and low dairy prices. This will be worrying the Reserve Bank and also weighing towards further rate cuts. If our rate doesn't move it is going to start to look attractive to currency investors pushing our dollar up. Nevertheless the consensus of economists at ANZ, ASB and Westpac is that there will be no move this week, with the first cut likely in June and a second in September.

At Capital Economics in Sydney economist Paul Dales is more enthusiastic about the chances of Wheeler throwing caution to the wind and cutting on Thursday. There was a "real chance" the bank would surprise, he said.

"We think the chances of 0.25 per cent cut are higher than the market believes."

But if Wheeler holds firm then all the interest on Thursday will be in the wording of his statement which is expected to point towards cuts in the near future.