The Reserve Bank surprised no one by cutting its official cash rate at yesterday's official cash rate review. The challenge now facing the central bank lies not in holding inflation down, but in holding it up.
In line with market expectations, the bank cut its official cash rate to 2.75 per cent from 3 per cent.
However, the tone of its comments was more "dovish" than expected, emphasising the downside risks to the economy and talking up the likelihood of further rate cuts.
Reserve Bank Governor Graeme Wheeler said the economy was adjusting to a lower exchange rate, but "further depreciation was appropriate".
His comments drove the kiwi down by more than US1c to US62.80c. The bank estimates GDP growth is running at 2 per cent from 3 per cent earlier in the year. The Reserve Bank's main goal is price stability, and it has had little to worry about on the inflation front in recent years.
The bank defines price stability as annual increases in the consumers price index (CPI) of between 1 and 3 per cent on average over the medium term, with a mid-point target of 2 per cent.
The last time inflation got close to 2 per cent was in 2011, when the CPI rose 1.8 per cent. Statistics NZ figures show the CPI rose by 0.4 per cent in the year to June - well below the mid-point.
In yesterday's statement, Wheeler said: "A reduction in the official cash rate is warranted by the softening in the economy and the need to keep future average CPI inflation near the 2 per cent target midpoint. At this stage, some further easing in the official cash rate seems likely."
Economists said inflation had been below the mid-point for several years and was too close to deflation - when prices fall - for comfort.
"Except for a GST-induced spike a few years ago, inflation has drifted lower and lower," Westpac chief economist Dominick Stephens said.
"Now, headline inflation is well below the target range for the Reserve Bank.
"With inflation clearly below the target, we are now going into an economic slowdown, and that threatens to push inflation down further.
"So the Reserve Bank is in a spot of bother in terms of reaching its target, and yes, the concern is that it might miss its target on the downside."
The bank had to create some inflation quickly.
"Fortunately, exchange rate changes are quite a rapid way of moving inflation one way or another."
Deflation is seen as a more destructive force than inflation as it is more difficult to control, and is generally associated with recessions or depressions.
Westpac expects another rate cut next month, although Stephens said it was a 50/50 call.
ASB economist Chris Tennent-Brown said there were concerns about inflation being too low.
"It's a bit off deflation but it is dangerously close to it," he said.
"We see downside risks to the Reserve Bank's inflation forecasts."
ASB expected another rate cut over the next quarter and perhaps more next year.
Wheeler defended the bank's decision last year to raise official rates, despite the move being out of kilter with nearly all other central banks around the world.
Between March and July last year, the bank raised rates four times to 3.5 per cent, helping drive the New Zealand to near post-float highs of more than US88c.
Wheeler said he didn't think it was the wrong decision.
"You always operate on the information you have available at the time ," he said. "I don't think any forecaster, economist or commentator believed oil prices would fall by 55 per cent from the middle of last year or that dairy prices would fall by a similar amount." .
In his statement, Wheeler said global economic growth remained moderate, but the outlook has been revised down, mainly because of weaker activity in developing economies.
"Concerns about softer growth, particularly in China and East Asia, have led to elevated volatility in financial markets and renewed falls in commodity prices," he said.
Activity had also slowed because of the plateauing of construction activity in Canterbury, and a drop in business and consumer confidence.
There and back again
• Yesterday - 2.75%
• July 2015 - 3%
• June 2015 - 3.25%
• July 2014 - 3.5%
• June 2014 - 3.25%
• April 2014 - 3%
• March 2014 - 2.75%
• January 2014 - 2.5%
Building permit increase pleases Wheeler
Strong new Auckland residential building consent data has given the Reserve Bank optimism about Auckland's stretched housing market.
Governor Graeme Wheeler cited the rising consent numbers as a bright spot in the Auckland housing sector when he gave his post-OCR media briefing in Wellington yesterday.
"The good news is that [Auckland] residential permits are running at around 8500 [annually]. Now that's quite a step-up, about a 20 per cent step-up up over the last year and it's the highest rate - largest number - of permits for about a decade so that's promising," he said. "What's required to get on top of the Auckland housing market is to address the supply shortages and that's why these residential permit numbers are so important, to see what the trend is there."
Latest Statistics NZ data also showed 1116 consents issued in Auckland in July alone, up 267 consents in a month.
Wheeler said Auckland demand for new housing was extremely strong.
"I think the existing housing shortage - according to some of the council figures - is somewhere between 15,000 and 25,000 houses and the Auckland Council said they need basically about 10,000 houses a year over the next three decades.
"Permits are currently running at 8500. Part of the challenge is that migration flows are very strong," Wheeler said, citing 55,000 annual arrivals and about half of those people were coming to Auckland and the occupancy rate is about three per house. "So that means - just dealing with the migration flows - you need about another 8000 houses a year or more. What's worrying is if you look at the house price to income ratio in Auckland, it's around nine. For the rest of the country, it's four and a half. A ratio of nine puts Auckland house prices in a grouping of cities which are probably the most expensive cities in the world.
"Secondly, if you look at investors' expectations for Auckland, there was a survey by ANZ late last year which indicated that over the next five years, investors were expecting house prices to rise by about 12 per cent a year, so cumulatively about a 75 per cent increase. House prices in Auckland are increasing rapidly and becoming more unsustainable. Residential construction is increasing in Auckland but it takes some time to correct the imbalances."
He was then asked when the market might turn, given lower sales price data out lately.
"[It's a] little bit early to say whether it's cooling down. What's required to get on top of the Auckland housing market is to address the supply shortages and that's why these residential permit numbers are so important, to see what the trend has been. We've always said that macro prudential policy can really help to try to slow the rate of increase but it can't solve the Auckland housing problem, not by any means."