What should an inflation-targeting central bank do when inflation is proving unexpectedly slow to make an appearance?
Put interest rates on hold and try to figure out why.
As expected, Reserve Bank governor Graeme Wheeler left the official cash rate on hold at 3.5 per cent yesterday, as the bank embarks on a period of "monitoring and assessment" before considering further rises.
Graeme Wheeler, Reserve Bank governor. Photo / Mark Mitchell
The bank's interest rate projections are now half a percentage point lower by the end of 2016 than they were in June, though still a full percentage point higher than they are now.
The kiwi dollar dropped half a cent after the release of the monetary policy statement, to trade around US82c.
Apart from the blip when the GST rate was increased, inflation has been well below the bank's 2 per cent target for the past four years and it expects it to remain below 2 per cent for a couple more years - more than a year longer than it tipped in June.
That is even though economic growth has been running a full percentage point stronger than the rate the bank sees as sustainable in the medium term, given such basic factors as labour force and productivity growth, and despite an unexpectedly strong surge in net immigration.
The bank has nudged up its estimate of what that sustainable rate is, to 2.9 per cent. "This is a key assumption justifying why the Reserve Bank can afford to take a lengthy break," said ANZ chief economist Cameron Bagrie.
It is not only consumer prices which have been rising more slowly than past relationships would suggest, the bank believes. House price inflation is easing and more so than past relationships with immigration and interest rates would have implied.
Because of high household debt, interest rate increases may be having a stronger effect on demand than in the past. And the traditional view is that a net inflow of migrants boosts both the demand and supply sides of the economy, but demand sooner.
But the bank now believes net immigration is having a more muted and more lagged effect on house prices than in previous cycles. "A larger share of the increased arrivals comprises younger working-age people and people on temporary work visas. These groups may demand less housing than permanent arrivals or those with families," it says.
Bank of New Zealand head of research Stephen Toplis said the economy was evolving in a way that should be creating inflation but wasn't. "Ultimately, the control of inflation is the Reserve Bank's primary mandate, so, if inflation is under control and looks likely to stay that way, despite the increasing pressure on capacity, then why push interest rates any higher until that link between capacity utilisation pressures and inflation re-asserts itself?" Toplis said.
It also has to weigh the impact of export dairy prices nearly halving from their peak last February.
It sees a bit of a bungy cord there, expecting the build-up in Chinese inventories of dairy products to clear in coming months. The decline in forest product prices, it suspects, is more reflective of underlying demand.
So far the exchange rate, though 6c off its peak against the US dollar, has not reflected the fall in the terms of trade and remains unjustifiably and unsustainably high, in the bank's view.
"We expect a further significant depreciation," Wheeler said. He pointed to market expectations that it will not be until about next April before he starts raising NZ interest rates again, by which time the foreign exchange market will be focused on looming interest rate rises in the US and England - lessening the risk of upward pressure on the kiwi dollar from interest rate differentials.
Westpac chief economist Dominick Stephens said it was important the bank's lower interest rate projections were driven not by weaker economic data but by the fact that the run of low - and lower than expected - inflation outturns over the past couple of years had prompted it to reassess some crucial economic relationships: between migration and house prices, between housing and the wider economy, and between growth and inflation.
"Forecasts will always ebb and flow as new information arrives," he said. "But when the Reserve Bank makes a judgment about the relationships inherent in the economy, it tends to stick with that judgment for some time.
"Unless the bank now gets hit by a string of stronger than expected inflation figures ... the message will remain one of low interest rates for longer."