RBNZ says inflation outlook has weakened due to 6% rise in NZ$ since June 9; says 'decline in exchange rate needed' as it's making it hard for RBNZ to meet inflation target; says likely further easing required

Reserve Bank Governor Graeme Wheeler speaking at the June 9, 2016 Monetary Policy Statement news conference. Photo by Lynn Grieveson for Hive News.

By Bernard Hickey

The Reserve Bank has signalled further cuts in the Official Cash Rate (OCR) are likely after it warned the 6% rise in the New Zealand dollar since its last OCR decision on June 9 was making it hard for the Reserve Bank to meet its 1-3% inflation target.

It said a decline in the currency was needed.

The New Zealand dollar dropped just over half a cent to 69.7 USc and economists said the dovish statement made a 25 basis point cut in the OCR on August 11 almost certain, along with the potential for more later in the year. Kiwibank’s economists said OCR cuts below 1.5% were possible.

The Bank, rather than Governor Graeme Wheeler, said the prospects for the global economy had diminished since June 9 despite very stimulatory monetary policy and low oil prices and there were many uncertainties about the outlook.

“The trade-weighted exchange rate is 6 percent higher than assumed in the June Statement, and is notably higher than in the alternative scenario presented in that Statement. The high exchange rate is adding further pressure to the dairy and manufacturing sectors and, together with weak global inflation, is holding down tradable goods inflation,” the bank said.

“This makes it difficult for the Bank to meet its inflation objective. A decline in the exchange rate is needed.” it said.

The bank noted house price inflation was excessive and had become more broad based, which added to concerns about financial stability. It noted its plans for strong macro-prudential measures to control those risks.

The bank then cited annual CPI inflation was 0.4% in the year to June.

“Headline inflation is being held below the target band by continuing negative tradables inflation. Long-term inflation expectations are well-anchored at 2 percent, but short-term inflation expectations remain low,” it said.

“Despite rising capacity pressures and some recent increase in fuel prices, the stronger exchange rate implies that the outlook for inflation has weakened since the June Statement. Monetary policy will continue to be accommodative. At this stage it seems likely that further policy easing will be required to ensure that future average inflation settles near the middle of the target range.”

The New Zealand dollar initially dropped almost half a cent to 69.7 USc, which was its first time below the 70 USc mark since late June, but still well above the 67 USc seen before the Reserve Bank’s June MPS.

The bank may be disappointed by the relatively timid initial market reaction, although the currency has fallen from 73 USc since the bank signalled this statement would be made.

Economist reaction

ASB Senior Economist Jane Turner said the Reserve Bank had strengthened its easing bias in the statement by saying an easing was likely.

“More importantly, the RBNZ made very strong comments about the strength of the exchange rate and how it “makes it difficult for the Bank to meet its inflation objective”.  The RBNZ explicitly stated a decline in the exchange rate is needed. This suggests the RBNZ has opened the door to OCR cuts below 2%, a move the RBNZ had previously indicated a very high threshold for doing so,” Turner said.

“The RBNZ has previously been reluctant to cut interest rates further due to financial stability risks. This week’s proposed tightening of LVR restrictions helps them on this front,” she said. 

Westpac Acting Chief Economist Michael Gordon said recent statements by the Reserve Bank had left the market with the mistaken impression that the strong housing market could prevent interest rates being eased further.

“Today’s statement was clearly arranged to dispel that view, and to reassert that meeting the inflation target remains the RBNZ’s primary duty,” Gordon said.

“We have maintained the view that the OCR would be cut to 2% in August, and today’s statement seals the case. It also seems likely that the AugustMPS will leave the door open to further interest rate cuts if the currency remains elevated,” he said.

Kiwibank’s Economics team said they still expected another 25 basis point cut on August 11, but it now expected the Reserve Bank to cut the OCR by another 50 basis points to a terminal rate of 1.5%.

“In addition, there is a risk that the OCR may even need to be cut further if the NZD does not respond to further OCR cuts – as highlighted in the downside scenario in the RBNZ’s June MPS,” Kiwibank’s economists said.

ANZ Senior Economist Philip Borkin said the Reserve Bank’s statement effectively signalled a return to a Monetary Conditions Index (MCI) focus, “and opens the door to additional monetary policy easing.”

“Together with the latest LVR limit proposal, the RBNZ appears to have gone into full attack mode in an attempt to tackle some of the considerable tensions it is facing,” Borkin said.

“Admittedly, we’re not convinced the economy actually needs more easing right now (at the margin we think capacity is being eaten into faster than the RBNZ assume). But by the same token, inflation remains too low, and we acknowledge that rate cuts are coming. Global interest rates are plunging, and in a world of currency divergence (from fundamentals), interest rates ultimately need to converge,” he said.

“The signal from the Bank today is that an August OCR cut is very likely; as is at least one further cut beyond that (our current forecast is February). But for the market to push a more aggressive easing cycle beyond that we need to see concrete action from the RBNZ, as well as evidence that the domestic data flow is turning and macro-prudential tools are biting. That may be some way off yet.”

(Updated with more detail, reaction)