Cutting observations on Reserve Bank policy

By BRIAN FALLOW economics editor

The Reserve Bank has been too timid in cutting interest rates and will have to ease by another full percentage point by the end of the year, Deutsche Bank says.

That is about three times as much easing as the money market is pricing in, but Deutsche Bank's chief economist, Ulf Schoefisch, believes the market is being too complacent about the exchange rate and what it will do to the economy.

Schoefisch, who recently returned from talking to institutional investors in the United States, says the fact that New Zealand has the highest interest rates in the developed world is not lost on them.

"At the moment they are looking for yield so interest rate differentials are playing a big role [in the exchange rate]."

The steep appreciation over the past 18 months, in the context of a sluggish world economy, has taken the wind out of the export sector's sails and will see growth in the wider economy halve to an annual rate of around 1.9 per cent by March next year. Without the boost to demand from strong net immigration, the slowdown would be greater still, Schoefisch said.

The strong dollar has also been driving down inflation in the tradeables (exporting and import-competing) sector. That has been offset by rising inflation in the non-tradeables or domestic sector, especially related to housing.

But Deutsche Bank, in its latest quarterly forecasts, says non-tradeables inflation turned around in the March quarter, and, when combined with the continuing effects of the strong dollar on import prices, will push overall inflation close to the bottom of the Reserve Bank's 1-3 per cent target band next year.

The Reserve Bank's own inflation projections in the June monetary policy statement have it bottoming out around 1.75 per cent, but Schoefisch said that reflected its purely technical assumption that the New Zealand dollar will fall 5 per cent over the year ahead.

He expects the dollar to continue to strengthen, to US61c by next March and 62c a year later - more if the Reserve Bank does not cut interest rates by the full 100 basis points he predicts.

Given the rapid slowdown in growth and subsiding inflation pressure, the Reserve Bank has been too slow in cutting interest rates, Deutsche Bank says.

The horizons it should focus on were a year from now. By then the economy's resources will no longer be overstretched and inflation will be in the bottom half of the target zone.