Governor says will interpret 1-3% inflation target flexibly in defiant speech; says won’t be ‘mechanistic’ about cutting rates just because CPI inflation below 1-3% target; Auckland still a financial stability risk

Reserve Bank Governor Graeme Wheeler at an earlier Monetary Policy Statement news conference.

By Bernard Hickey

Reserve Bank Governor Graeme Wheeler has confronted critics who argue he should cut the Official Cash Rate more aggressively to ensure headline inflation rises back into the bank’s 1-3% target range.

Wheeler used his first speech of the year to criticize those calling for immediate OCR cuts, saying he planned to use the flexibility built into his Policy Targets Agreement (PTA) with Finance Minister Bill English and would not “mechanistically” make cuts to increase the inflation rate. He used half of his annual speech to the Canterbury Chamber of Commerce to defend his actions within the PTA.

He said he was surprised by the wide range of interpretations of his current 2012 agreement and pointed to some commentators who advocated immediate interest rate cuts.

“A mechanistic approach can lead to an inappropriate fixation on headline inflation,” Wheeler said.

“It would cut across the flexibility deliberately built into the PTA framework, and risk creating serious distortions in the financial system, housing market, and broader economy,” he said.

Annual CPI inflation was 0.1% in the December quarter and it has been below the 1% bottom of the range for more than a year. It has been below the 2% mid-point of the target for four years. ASB, Westpac, HSBC and First NZ have all called on the Reserve Bank to cut the OCR by as much as a further 50 basis points to 2.0% this year.

Wheeler’s speech underlined the sections of the PTA that referred to the target being for 1-3% “on average over the medium term” and with a focus on keeping “future average inflation near the 2% target mid point.” He also underlined the PTA’s requirement the bank “monitor asset prices, have regard to the efficiency and soundness of the financial system and seek to avoid unnecessary instability in output, interest rates and the exchange rate.” He said a flexible approach was needed to take account of the various factors in the PTA.

“All of these factors have bands of uncertainty attached to them. There are also uncertainties as to which transmission channels monetary policy will operate through and the lags involved in achieving desired outcomes,” he said. Wheeler said the very low CPI inflation rate was due to deflation in the tradables sector and a slump in the oil price.

“Low oil prices are recognised in the PTA as a factor that can legitimately cause inflation to be outside the target band. It would be inappropriate to attempt to offset the low oil price effect through the OCR, which tends to influence inflation outcomes over an 18 month to 2 year horizon,” Wheeler said. The bank’s goal was to anchor inflation expectations close to the mid-point of the price stability target range.

“Looking ahead, monetary policy will continue to be accommodative. With the ongoing weakness in commodity prices, and particularly oil, it will take longer for headline inflation to reach the target range,” he said. Wheeler said annual core inflation at 1.6% was well within the target range and the bank’s combined measure of annual inflation expectations was at 2%. This was “more encouraging in terms of consistency with the PTA.”

“However, we would not wish to see inflation expectations become unstable and decline significantly,” he said.

Easing bias retained

Wheeler’s specific comments about the outlook for the OCR were little changed from the bank’s January 29 statement.

“If concerns deepen around the prospects for the global economy and its impact on New Zealand, some further policy easing may be needed over the coming year to ensure future average inflation settles near the middle of the target range,” he said.

“We will continue to monitor closely the emerging economic and financial data.”

Auckland still a risk

Wheeler said the bank believed that imbalances in Auckland’s property market posed a financial stability risk.

“Record low interest rates, along with record net migration inflows, strong bank lending, heightened investor activity, and insufficient housing supply have led to strong house price inflation in Auckland and an average house price to income ratio over 9.5 that is 70 percent higher than in the rest of the country,” he said.

“In addition, house price inflation has been accelerating in Waikato/Bay of Plenty, Northland and in Central Otago,” he said.

“Recent indicators suggest that housing activity in Auckland may be beginning to slow as a result of the Government’s measures introduced on 1 October 2015 and the macro-prudential policy measures applying to investor-related lending. We will have a better feel for this when we see the February and March 2016 housing data.”