Crunch time nears for Brash

By BRIAN FALLOW

Cut or sit tight? Although the verdict will not be handed down until March 14, next week is the crunch week in the Reserve Bank's quarterly cycle for deciding whether it needs to adjust interest rates.

The collective view of the money markets, as expressed in 90-day bank bill futures, is that there is a 50:50 chance governor Don Brash will cut rates by 25 basis points next month.

A rate cut would be despite, not because of, what the economic indicators are saying about the state of the domestic economy.

Instead, the case for a cut rests on the outlook for the world economy, the United States in particular, and its implications for the export-led recovery now under way in New Zealand.

Advocates of a cut are sceptical of the view that the US will have a "V-shaped" recovery this year - ie, that it will bounce back as sharply as it declined.

Proponents of the rival "U-shaped" recovery scenario argue that major imbalances built up in the US economy over a decade of expansion will not be so quickly corrected.

The V-shaped view is in the ascendancy. It was implicitly endorsed last week by Federal Reserve chairman Alan Greenspan in his testimony to the Senate banking committee. The continued strength of the US dollar and of commodity prices indicates those markets are betting he is right.

Given the United States' role as a locomotive of world demand - reflected in a trade deficit running at $US1 billion a day - the effects of a US slowdown would be amplified by the impact on other trading partners, notably in Asia, but also Australia which is already slowing of its own accord.

National Bank chief economist Brendan O'Donovan considers the international outlook dark enough to warrant a rate cut next month.

The New Zealand economy has good momentum but it is coming from the export sector rather than domestically focused sectors which would be stoked by a drop in interest rates, Mr O'Donovan says. "So a quarter-point cut in interest rates would be a fairly low-risk move by the Reserve Bank." If it proved unnecessary, it could be taken out again later, no harm done.

Deutsche Bank chief economist Ulf Schoefisch is in the no-change camp. "We are not saying we can escape the US downturn. If the US hadn't turned down, our growth rate this year would have been something like 4 per cent. Now we are looking at between 2.5 and 3 per cent, reflecting lower export growth."

But that is not the sort of growth rate requiring further stimulus from lower interest rates, Mr Schoefisch says.

With emigration retarding growth in the labour force and an unimpressive record in productivity growth, New Zealand's sustainable potential growth rate is around 2.5 per cent.

"With actual growth pretty close to potential, anything that would stimulate things further would mean the economy would be running too hot - too hot for Don Brash's liking anyway."

Because of the weak exchange rate, overall monetary conditions in New Zealand remain stimulatory, even with short-term interest rates at neutral levels.

The hawkish view, as put by Mr Schoefisch, is that: "Lower interest rates will do little to help those exporters feeling the pinch from the temporary slowdown in global growth. Rather, the Reserve Bank can rely on the very rapid action being taken by the Fed and other central banks to underpin demand for New Zealand's exports.

"Moreover, by adding stimulus to the domestic sector of the economy at a time when it already appears set to recover strongly, the Reserve Bank might inhibit the current transfer of resources to the external sector, hurting New Zealand's longer-term growth prospects."

Advocates of a rate cut point to the weakness of retail sales in the December quarter, when in real terms sales fell 0.4 per cent.

But WestpacTrust chief economist Adrian Orr does not think that indicates growth in the rest of the economy. "We think it is more of a timing issue. Consumers appear to have reined in their spending following the surprise beat-the-price-hike spend-up in the September quarter, when they sought to avoid exchange rate-related price rises."

UBS Warburg's Robin Clements said the "spectacular" recovery in business and consumer confidence late last year, coupled with the income growth arising from employment growth and wage growth, suggested the domestic economy would improve. "But we are not talking boom times here."

Mr Greenspan said last week that the Fed could cut interest rates aggressively only because US inflation remained subdued.

Dr Brash is in a less comfortable position. Headline inflation hit 4 per cent last year.

About a third of the annual increase can be put down to factors the Reserve Bank is expected to ignore for policy purposes, notably oil prices and a rise in tobacco tax.

But core inflation continued to rise and price increases were more widespread than in September. Nearly 64 per cent of all the items in the consumers price index rose, compared with 54 per cent in September.

In addition, the labour market is tight. The unemployment rate is at a 12-year low. Skilled labour is scarce. Anecdotally, wage settlements are running around 3 per cent. The new, union-friendly labour law is less than five months old. The risk of a return to the wage-price spirals of old is not one Dr Brash can be expected to take lightly. On the other hand, he will be wary of repeating the policy mistake of 1998, when the Reserve Bank, still entangled in the ill-fated monetary conditions index, was too slow to ease after the Asian crisis.

"The hurdle for a rate cut is high," says Mr Schoefisch. "The bank would do it only if it was convinced it needed to support the economy."

He believes Dr Brash will fold his arms and do nothing next month. But a rate cut in May would still be possible if, by then, there was consensus that the US would not enjoy a V-shaped recovery.