Bank agonises over rate cut

By BRIAN FALLOW economics editor

By cutting the official cash rate 25 points to 6.25 per cent yesterday, Reserve Bank Governor Don Brash has slung a safety net under the tightrope he is walking.

It was a finely balanced decision. He told finance and expenditure committee MPs that he made the decision only on Monday, and that his inclination two weeks ago, when the text of the monetary policy statement was finalised, was not to move.

The risk involved in cutting the rate is that it will further stoke an economy that - unlike those of our trading partners - is still gathering momentum.

With a tight labour market and real wages having fallen, with importers' margins still compressed from a prolonged depreciation, and with the consumers price index sitting at 4 per cent, the risks of inflation are high.

But with the news from the international front getting worse by the day, the prospect that economic growth, and with it inflation pressure, will ease significantly in the period monetary policy targets - the second half of next year - is now the greater risk, in Dr Brash's judgment.

The cut in the official cash rate could be seen as an insurance premium against that risk, he said.

"We are as keen to avoid inflation falling too far below the mid-point of our target range as we are to avoid its rising too far above it."

Deutsche Bank chief economist Ulf Schoefisch said that from the Reserve Bank's point of view the rewards of an "insurance" easing outweighed the risks.

If the international outlook worsened, it could build on these cuts. It would look proactive and show that it had learned from its mistake in 1998, when it took too long to ease effectively after the Asian crisis.

But if the global outlook improved and became less of a drag on the New Zealand economy than expected, the cut could easily be reversed.

With the uncertainty prevailing, people would be unlikely to be scornful of a flip-flop.

After the announcement 90-day bank bill futures rallied; the market is now pricing in a further 50 basis point rate cut by mid-year.

WestpacTrust chief economist Adrian Orr agrees, notwithstanding Dr Brash's warning yesterday that it would be unsafe to assume there would be more rate cuts where that one came from.

"He was just as explicit three months ago that the next move would be a tightening," Mr Orr said.

"The half-life of these projections is not long."

"There's a feeling [in the market] that the hardest decision for the bank is whether to move. Once you have made that decision it is the harbinger of plenty more to come."

Mr Orr expects Dr Brash to cut again, by 50 basis points, in May.

An official cash rate of 5.75 per cent would be unambiguously stimulatory.

In his appearance before the finance committee, Dr Brash said the bank's focus remained on inflation.

"We don't have some surreptitious growth objective. But the [inflation] target is a medium-term target. So if growth is going to be slower than potential, that has implications for inflation.

"The upside risk to inflation driven by what is a pretty buoyant economy would suggest we should not be cutting, and might even be tightening.

"But offsetting that effect in the medium term is a modest appreciation in the exchange rate and the prospect that the world economy could turn out to be weaker."

ANZ Bank chief economist Bernard Hodgetts said the Reserve Bank's projections for growth (3 per cent or better over the next three years) and for inflation (1.5 per cent) could be reconciled only if it thought the potential growth rate had gone up.

In fact, with slow growth in the workforce and weak productivity the potential growth rate would, if anything, have fallen lately, and might not be much more than 2 per cent.