Inflation is likely to undershoot the Reserve Bank's forecast in 2016 because of an unexpectedly strong kiwi dollar, adding to the case for deeper interest rate cuts, Westpac Bank economists say.

The trade-weighted index was recently at 72.92, more than 7 per cent above the average 67.9 level the central bank projected for the fourth quarter in its September monetary policy statement. While the TWI sank as low as 68.18 in late September, it has since rebounded to a five-month high, instead of following the central bank's forecast track for a decline running through late 2016.

Governor Graeme Wheeler cut the official cash rate to 2.75 per cent in September while flagging a further 25 basis point cut, which may come as soon as the December 10 MPS. Westpac chief economist Dominic Stephens says Wheeler will have to cut the OCR to 2 per cent to achieve a rebound in inflation next year.

"Boosting inflation from today's low rate to 2 per cent on a sustained basis will be a daunting task for the RBNZ," Stephens said. "The RBNZ is firmly of the view that the OCR will have to fall to 2.5 per cent, but no further. In our view, the OCR will eventually have to fall to 2 per cent."


Westpac is forecasting annual inflation to rise to 1.2 per cent in the 12 months ending September 30, 2016, from 0.4 per cent in the September 2015 year. That's well below the Reserve Bank's forecast of 2.1 per cent. Westpac doesn't expect inflation to return to the mid-point of the central bank's 1 per cent-to-3 per cent target range until September 2017.

Stephens said the Reserve Bank got it wrong in September when it argued a lower exchange rate would provide a "substantial and sustained" boost to inflation by boosting the cost of imported goods, and therefore tradables inflation. Uncertainty about the timing of a rate hike by the Fed, a lift in dairy prices and a sturdy domestic economy have helped underpin the kiwi dollar, while concerns have abated that China is heading for a slowdown.