Why is the Reserve Bank cutting interest rates when inflation is expected to rise over 5 per cent this year?

Why is it cutting interest rates back to a record low when commodity prices are at record highs and the bank has lifted its own inflation forecasts in its Monetary Policy Statement?

The simple answer is the bank wants to give the economy a confidence boost to ward off an "especially severe downturn".

But there is a strong case that the Reserve Bank should have left the Official Cash Rate on hold at 3 per cent and the bank acknowledges this in its own Monetary Policy Statement.

Academic research has found that natural disasters such as an earthquake or hurricane will trigger inflation in the following years as intense rebuilding work pushes up the cost of materials and services. Higher rents and insurance costs also feed through into inflation.

Here's what the Reserve Bank itself says (with my emphasis bolded):

"The earthquake will be causing some prices to increase. Most notably, rents - both for residential and commercial premises - are likely to increase over the next few weeks. This effect is likely to be felt outside of Christchurch given the flow of people temporarily leaving the area. In addition the cost of insurance is likely to increase."

"The earthquake's more persistent impact however, is the likely boost to inflationary pressure generated by the mobilization of resources required for the rebuilding of Canterbury. Because reconstruction is likely to take many years, this inflation impulse could prove persistent."

"Given monetary policy's focus on the medium term trend in inflation, it would therefore be inappropriate, all else equal, for monetary policy to be stimulatory during reconstruction."

So the Reserve Bank itself is saying the earthquake could trigger a "persistent inflation impulse" through the economy.

So why is it cutting?

Here's the Reserve Bank's argument.

"In the near term however, the earthquake is clearly having a negative impact on activity. It is difficult to know how large or how long lasting this impact will be, but there is a risk that the downturn is quite severe. To guard against this risk it is appropriate for monetary policy to become more supportive.

"Lowering the OCR should be regarded as an insurance measure, designed to help offset the negative economic effects of the earthquake until such time as rebuilding - and a recovery in the broader economy - act to draw on the economy's surplus resources."

The Reserve Bank also pointed out that many borrowers are now on floating rates, which gives the Reserve Bank the flexibility to reverse the easing quickly.

This assumes the move to floating from fixed continues, given that still less than 50 per cent of the mortgages in New Zealand are floating. There is a risk of a reversal of that trend if the banks keep their fixed rates below their floating rate, as has been the case for the last week.

Monetary policy is a blunt instrument and a double edged sword at that.

A lot of retirees in Christchurch and elsewhere are about to see their incomes from term deposits slashed.

There is a danger that just as this monetary policy easing is flowing into the economy in earnest in 12 months to 18 months time, the inflation from the rebuilding effort and inflation from higher commodity prices globally hits the economy in a double whammy.

I think the Reserve Bank should have waited for more data on the true impact of the earthquake and put a bit more faith in the resilience of the New Zealand economy.

It has now opened up the risk that a slow growing economy is burdened by inflation and higher unemployment. Today's cut may be seen as the day New Zealand invited in stagflation.