Bearish Fed boosts odds on Brash rate cut

By BRIAN FALLOW Economics editor

Further cuts to New Zealand interest rates may be in sight after the United States Federal Reserve yesterday shaved another half a percentage point off rates - the third such cut this year.

The cut had been widely expected and many had called for 75 basis points.

But the markets were rattled by the tone of a statement from the Fed's open market committee that was more bearish than its January views.

It spoke of persistent pressures on companies' profit margins, which had not only restrained business investment but also, through lower share prices, restrained consumer spending.

Excess productive capacity had emerged and could persist for some time, the Fed said. It also cited the potential for weakness in the global economy.

All this suggested "substantial risks that demand and production could remain soft."

The V-shaped recovery implicit in the Fed's January statements seems to have sagged into something more U-shaped.

National Bank chief economist Brendan O'Donovan said the Fed appeared to be backing away from its previous story that the US was just going through an inventory correction and was likely to rebound quickly to stronger growth.

"We are now rapidly heading towards the alternative scenario the Reserve Bank sketched in its monetary policy statement last week, where trading partner growth is 1 per cent below trend and the [New Zealand] interest rates around 1 per cent below where they are now," Mr O'Donovan said.

On this scenario, 90-day interest rates would hit 5 per cent by late next year, implying floating mortgage rates around 7 per cent. They are now at 8.25 per cent.

The consensus forecast was for world growth to drop 1 per cent below trend, to be about 2 per cent.

"But the March consensus forecasts are halfway there, and with sentiment changing as quickly as it is we are quickly getting to the bank's alternative scenario," said Mr O'Donovan.

Westpac's David Croy said Reserve Bank Governor Don Brash had made it clear that he was prepared to cut rates because of continued softness in the global economy. "This still looks to be the environment we are operating within."

The latest US cut kept the odds on Dr Brash cutting by another 50 basis points on May 16, assuming that the Fed would have trimmed again by at least that much, Mr Croy said.

The futures market, which had already priced a further 50 basis point cut by the Reserve Bank by mid-year, rallied further yesterday. The June 90-day bank bill contract closed with an implied yield of 5.55 per cent.

Mr O'Donovan said the impact of slowing world growth on New Zealand would be nothing like the Asian crisis.

"It is helpful that we are starting with a dollar that is closer to 40USc than 70c. That is a substantial buffer."

Commodity prices were holding up well so far, Mr O'Donovan said, though that was more to do with supply-side factors such as the foot-and-mouth outbreak in Britain.

"Eventually the demand side will dominate and we will see weaker commodity prices. Export volumes will be weaker, too. New Zealand will feel this."

UBS Warburg has predicted a further 150 basis points easing by the Fed.

"Against a backdrop of shaky consumer confidence, deteriorating labour markets [rising claims for unemployment insurance], contracting household wealth and too-high inventories, the Fed is likely to reduce the funds rate to 4.5 per cent no later than the May 15 FOMC [Fed open market committee] meeting."