ASB economists argue RBNZ should be reducing interest rates; disagree with central bank's view of 'neutral' interest rate setting

ASB chief economist Nick Tuffley believes that the Reserve Bank won’t cut interest rates next week – but that it should.

The Official Cash Rate set by the RBNZ is currently at 2.75%. The RBNZ has given fairly strong hints it won’t drop rates next week, though it does see some further potential easing at some stage. But recent comments suggest the central bank doesn’t see the OCR going below 2.5%.

In a preview of the RBNZ’s Official Cash Rate decision on October 29 Tuffley says a significant reason for cutting sooner rather than later is the recent rebound in the value of the New Zealand dollar.

“The RBNZ’s medium-term inflation outlook is heavily dependent on tradable inflation rebounding and sustaining a pace at/above 2.5% until 2018, while non-tradable inflation remains subdued. The NZD’s rebound will see inflation languish below 1% for longer, and further delay a return of headline inflation to the 2% medium-term anchor.”

Tuffley says the RBNZ appears to be “pinning a lot of hope” on the US Federal Reserve pulling the NZD/USD down by raising US interest rates. (The Federal Open Market Committee also meets next week).

“But, its [RBNZ’s] own actions matter. If it chooses to keep the OCR on hold it can hardly complain if markets were to start doubting whether the RBNZ will cut again at all and push the NZD up even further.”

Tuffley says over the longer term ASB “are very wary that inflation will not lift to the extent the RBNZ currently expects”. ASB’s own inflation forecasts, at a 2.5% OCR setting, “do not reach 2% at any point over the next few years”.

He believes “there is scope” to drop the OCR below 2.5%.

He points to risks that tradable inflation turns out not as persistently strong over the next few years as the RBNZ assumes, in part due to the recent rise again in the NZD, but also a muted global inflation environment;

He also says there is a risk of wage pressure remaining subdued unless migration slows sharply soon. “We expect an unemployment rate near 7% as opposed to the RBNZ’s forecast peak of around 6.1%, with migration boosting labour supply.”

Tuffley believes that house price concerns [raised again last week in a speech by RBNZ Governor Graeme Wheeler] are best left to macro-prudential policy, “rather than holding broader economic growth hostage to those concerns”.

And Tuffley says that the RBNZ’s estimate of the “neutral” interest rate “risks being too high”.

“Recent research from the RBNZ implies a ‘neutral’ OCR setting is 4-4.25%, but we think this is too high,” Tuffley says.

“This research is based off a variety of estimation techniques of this unobservable concept. There is a large degree of uncertainty among the wide range of estimates. A few of these models suggested the neutral 90-day rate was closer to 3.8% (implying around a 3.5% OCR) – which seemed more plausible to us.

“To us, it just does not seem like monetary policy is very stimulatory right now. The extent of stimulus (or restriction) is judged relative to the assumption of neutral. So, another perspective to consider is how the economy is responding to the current level of interest rates. The RBNZ’s 4-4.25% assumption suggests the current 2.75% OCR is 125-150bp into stimulatory territory.

“However, we have an economy that is struggling to grow above 2-3%, with a large degree of slack remaining and unemployment struggling to fall convincingly. Credit growth is positive, but not impressive. It is worth remembering that since the OCR first reached 2.5% in April 2009 it has only been above 2.5% for 28 months out of 77. And the OCR was last at 4% 7 years ago.

“From a risk perspective, deflation is far more dangerous and damaging than inflation being modestly too high. Cutting the OCR might run the risk of inflation flirting with 3% rather than 0.3%.

“Monetary policy is all about making decisions in the face of uncertainty, based off what is expected to influence future inflation outcomes. Inflation could well turn out to do just what the RBNZ currently expects – we just have our doubts.

“If inflation remains subdued there is an opportunity cost of foregone growth.

“To us making monetary policy decisions off a view the neutral interest rate is 4+% feels a bit like lending your car to Thelma and Louise: it may come back washed and waxed – but there is a nagging doubt things may not turn out as well as you’d hope,” Tuffley says.