Contrary to my expectation the Reserve Bank of New Zealand today cut the OCR 0.25% to 3.25%. The Bank’s interest rate track flags a further cut is likely.
While I had acknowledged the chance of lower interest rate this year I didn’t think the Bank would be prepared to pull the trigger today. When the Bank adopted its easing bias in April that bias came with conditions around weaker growth in demand and wage & price setting behaviours settling at levels inconsistent with 2% inflation. My view is those conditions may still not be met but the Bank has clearly been prepared to move in anticipation of them being fulfilled.
The primary rationale for today’s move appears to be the renewed weakness in dairy prices and the impact that will have on domestic demand. That is one of the factors we had identified, along with the TWI and wages, as ultimately determining the next move in interest rates.
Our concern about dairy prices had been ameliorated by the fact that the terms of trade has continued to hold up pretty well and would likely remain high relative to history. We have been expecting a fall of 7-8% overall – the RBNZ’s forecast is for a decline of 8.4%. That will still leave the terms of trade at around the level of its previous peak in 2011.
While the Bank has lowered its forecasts for domestic demand their growth forecasts are broadly in line with ours with GDP holding up at 3% this year and into next and then tailing off from later next year. With respect to capacity pressures the Bank believes the output gap is closed and will become positive over the forecast horizon.
So why did they cut? The big question is how much inflation that level of growth and a modestly positive output gap is going to generate and the appropriate level of interest rates that comes with that. Towards the end of today’s MPS (Box 2, page 29) the Bank acknowledges the uncertainty around the answer to those very questions. I thought the Bank would be prepared to wait for a bit longer for more certainty on the answers before cutting.
How wrong I was (I hate being wrong). I did think, however, that if the Bank did cut rates it would probably cut twice. Indeed the Bank’s interest rate track signals a second cut is in the offing. That appears likely at either the July OCR review or (more likely) the September Monetary Policy Statement. The precise timing will depend on the data flow.