Westpac economists say the bottom of the fixed interest market is close but has not been reached yet; see inflation remaining below 1% till next year

Borrowers who resisted the temptation last year to fix their interest rates will be pleased – because the low point for rates has not been hit yet, Westpac chief economist Dominick Stephens says.

The comments from Stephens come as wholesale interest rates have been quickly moving lower in recent days, with signs that banks might soon again be coming out with new lower fixed-rate mortgage special offers.

In his introduction to Westpac economists’ latest Economic Overview, Stephens says last year  the Westpac economists had “argued hard” that the Official Cash Rate would have to fall to 2.0% during 2016, “while the Reserve Bank itself charted a course for 2.5%” (which is the current rate.

“In January this year the Reserve Bank undertook a course correction, and signalled that the OCR may go lower after all. Borrowers who resisted the temptation to fix their interest rates will be pleased.,” Stephens says.

“In our view, the low-point in fixed interest rates is drawing nearer, but has not yet arrived.”

Stephens doesn’t indicate, however, how much further the Westpac economists think that fixed rates may go.

‘RBNZ will drop OCR’

But the Westpac economists’ view that fixed rates will go lower is based on their continuing view that the RBNZ will have to further lower the OCR, because inflation will continue to undershoot its expectations.

In fact – they predict that the rate of inflation will not even get back into the bottom of the RBNZ’s 1%-3% target range until next year.

That goes even further than BNZ head of research Stephen Toplis, who suggested last week that inflation targeting was “probably a waste of time” in the current environment and said he thought inflation would not get back above 1% till the last quarter of this year.

The RBNZ has previously forecast (as in its December Monetary Policy Statement) that the recent depreciation in value of the Kiwi dollar would help to push inflation back up again – to an annual rate of as much as 1.2% by as early as the March quarter this year.

However, in a speech last week, RBNZ Governor Graeme Wheeler appeared to pull back from those forecasts, saying that with the ongoing weakness in commodity prices, and particularly oil, it would “take longer for headline inflation to reach the target range”. On the other hand, he said, the data on core inflation and inflation expectations were “more encouraging” in terms of consistency with the Policy Targets Agreement (targeting 1%-3% inflation) between Wheeler and Finance Minister Bill English.

‘Inflation set to go lower’

The Westpac economists say inflation has been below the bottom of the RBNZ’s target band for over a year now, “and it’s set to push even lower”.

“In fact, it’s likely the latter half of 2016 will see annual inflation dropping to around zero, with a very real risk it goes negative. The only other time that’s occurred in the past 70 years was in 1999, and that was only because of a change in how the CPI was calculated.

“This softness in inflation isn’t just a near-term issue either. We don’t expect inflation will be back inside the RBNZ’s target band, let alone close to 2%, until 2017.”

The economists say a key reason for this weak inflation outlook is the 50% drop in global oil prices since the start of last year, which has resulted in sharp falls in petrol prices.

“The RBNZ’s medium term focus means that they look through temporary changes in inflation associated with volatile items like oil. Prices for such items can swing around quickly, and consequently can be an unreliable guide for setting policy. However, oil prices have already been low for some time. And this isn’t just resulting in lower petrol prices. Lower fuel costs have reduced prices for services such as air travel, and have dampened prices on shop floors as the distribution costs for retail items have declined. In addition, as discussed below, the low level of overall inflation resulting from falls in oil prices is weighing on inflation expectations.

“These developments, especially the latter, will be very hard for the RBNZ to ignore.”

It’s not just about oil

The Westpac economists say their forecasts for low inflation and the need for OCR cuts don’t just reflect movements in the price of one volatile commodity.

“Even excluding petrol prices, inflation has been below 1% for most of the past year, and it’s set to remain low through 2016.”

They say much of this weakness has been due to conditions offshore, with low global inflation holding down the prices of many imported goods, and this trend looks set to continue for some time given the recent deterioration in global trade and widespread falls in commodity prices. Domestic conditions are also dampening inflation. Structural changes in the retail sector, such as increased price competition and the growing prevalence of online trading, mean that pass-through from the lower exchange rate into consumer prices has been limited.

On top of this, lingering unemployment over the past year has limited pressure on wages.

All of this has resulted in a very soft underlying inflation environment.

“Measures of core inflation remain low, and even those that have picked up are only at modest levels,” the economists say.

“The RBNZ has highlighted that its preferred sectoral factor model measure of core inflation (which looks at the underlying trend in prices) sits within their target band at 1.6%.

Limited inflationary pressures

“However, even this measure actually demonstrates just how limited inflationary pressures are. Core tradables inflation has actually been remarkably muted given the 10% fall in the exchange rate over the past year, illustrating our point that a lower exchange will not generate enough of a lift in inflation to satisfy the RBNZ’s target.”

The Westpac economists say continuing downward pressure on inflation expectations is a major worry for the RBNZ.

“Inflation expectations are a significant influence on wage and price setting decisions, and as a result play an important role in determining actual inflation. If inflation expectations remain low or continue to fall, it will make the uphill battle the RBNZ has been fighting to generate a sustained lift in inflation that much harder.”

The economists say Wheeler’s speech last week reiterated an explicit easing bias, focussing almost exclusively on downside risks to the economy.

“However, the RBNZ did not sound as though it was in a hurry to reduce the OCR. Given the RBNZ’s hesitance, we think that it is most likely that we’ll see OCR cuts in June and August. However, this will be dependent on the flow of data, and March and April are certainly live decisions. Continued downside surprises in terms of inflation, inflation expectations, or a weakening in the global economy could force the RBNZ’s hand earlier than June.

The Governor’s speech also stressed the RBNZ’s flexible, medium-term approach to inflation targeting, the economists said. The Governor had counselled against focussing on the headline inflation rate of the moment when assessing what might happen to the OCR. That fitted “very well” with the Westpac economists own arguments, they said.

A medium-term view

“Our long-held view that the OCR will fall to 2.0% is based on our assessment of medium-term inflation, not today’s low rate of actual inflation.”

Stephens says the performance of the economy in recent months has been pleasing, “but there are still some things to keep an eye on”.

“The nation faces at least three years of below-cost returns in its biggest export industry, dairy. Surely it is only a matter of time before that has a more telling impact on the wider economy. And then we will face the wind-down phase of the Canterbury rebuild. I can’t help wondering whether confidence surveys will soon turn south again.”