The Reserve Bank of NZ continued to cut interest rates in recent months, dropping them a total of 0.75% since March as world economic growth lost its way. There is still scope for another cut, but will the RBNZ come to the party?

The RBNZ followed up its March 0.25% interest rate cut with two similar cuts in April and May. The Official Cash Rate (OCR) is now at 5.75%, down from 6.5% at the beginning of the year. As in March, the main reason for the successive cuts was the deteriorating growth outlook for key trading partners - the US and Australia in particular.

There is room for further cuts - based on the downward risks to inflation in the medium term. We expect a further 0.25% cut in August, with the possibility of a further cut in November. Whether these cuts occur depends on the RBNZ coming to the view that downward the medium-term inflation risks outweigh the short-term inflation pressures.

Short-term inflation indicators
In May the RBNZ noted that a number of near-term indicators of inflation still point to a degree of upward pressure on inflation, a reason for the RBNZ's recent caution on interest rates:

• Surveys indicate firms' levels of capacity utilisation are at high levels;
• The labour market has been, and remains, tight; and
• Wages have begun turning up.

The RBNZ is also unsure how much of the disinflationary benefits of an appreciating currency will be passed to consumers, given how compressed importers' and retailers' margins have become.

However, there are signs that short-term price pressures are easing:

• Import prices fell sharply in the first quarter of the year; and
• Inflation expectations and firms' pricing intentions are steadily easing, albeit from high levels.

Medium-term trends to dominate?
We believe that in the second half of this year, medium-term inflation influences will eventually sway the RBNZ's risk outlook and lead to lower interest rates. In our view, the medium-term inflation outlook has greater downside risk than the RBNZ currently judges. Relative to the May MPS, we see greater inflation downside from global developments through:

• Greater probability of a more prolonged period of slow US growth;
• Further deterioration in the global outlook as a whole, as US weakness spreads to Europe and Asia;
• Falling commodity prices - once the one-off factors such as BSE and foot-and-mouth work themselves through - according less insulation from slowing global demand;
• A lack of a strong export response to the low NZD, given that growth in export volumes has already begun slowing despite past strong world growth and the sustained weakness in the NZD to date.

Further medium-term influences that will keep inflation in check are:

• Lack of a strong link from rising wages to rising inflation;
• Relatively high levels of household debt and debt servicing costs that will increasingly induce households to consume within their means;
• A prolonged period of subdued asset prices (house and equity prices in particular) that give few capital gains to consume out of;
• Modest credit growth, by historical standards;
• Continued net outflow of migrants, which blunts demand in the housing sector in particular.

Overlaid on these considerations is the issue of the 'neutral' rate of interest. If interest rates are at neutral, monetary policy is neither stimulating nor constraining demand in the economy. Our analysis suggests that NZ's neutral short-term interest rate is between 5 and 6%. With the OCR at 5.75% monetary policy isn't stimulating demand - at a time when the economy needs to increasingly rely on domestic demand to maintain growth momentum. That suggests scope for further OCR cuts at little danger to inflation.

Timing of future cuts
In the short term, information about the domestic economy will likely appear quite positive, and hence not strongly supportive of further interest rate cuts. For example, Q1 GDP, released at the end of June, is likely to register a 0.5% increase compared to the December quarter last year. While such an outcome would be slightly weaker than most commentators - including the RBNZ - had been expecting, it is still positive growth. For this reason, we see the August MPS as the most likely opportunity to cut rates. However, recent weak data means a cut in July cannot be ruled out.

Short-term (90-day) interest rates are likely to remain rangebound between 5.6% - 5.9% through to August, when the RBNZ's view of medium-term inflation pressures is made clear. Any interest rate cuts will drive short-term rates modestly lower. Even if the RBNZ doesn't cut interest rates, short-term interest rates will be capped - the RBNZ isn't likely to begin raising rates until mid-2002.

To fix or float?
Longer-term interest rates have been rising internationally, dragging NZ rates with them. It thus appears as low as it goes in fixed rates for the time being, unless something dramatic happens in the global economy. If it is fixed rates you prefer, then now is not a bad time. If you prefer to float for a host of reasons, then there is still some possible downside left in floating rates. Either way, there is not a lot more to be gained for borrowers by waiting.

The exchange rate: poised for take-off?
To date, the NZ economy has maintained its momentum in the face of slowing growth in NZ's trading partners. However, the NZ dollar has remained in a holding pattern against the USD since the beginning of May. Relative to the Australian dollar, the NZD has retreated from the highs reached at the end of March.

The NZD remains undervalued on any measurement basis. The real (i.e. inflation-adjusted) trade-weighted exchange rate is some 20% below its post-float average - due entirely to the nominal exchange rate.

The economic fundamentals suggest the NZD will rise against the USD at some stage. NZ economic growth will continue to outperform that of the US over the course of this year and into 2002 as well. The current account deficit will improve sharply over 2001. Also, short and long-term interest rate differentials to the US have widened considerably of late, and will remain relatively wide over much of 2001.

However, the timing of a sustained rise in the NZD remains contingent on the relative merits of the NZ fundamentals being recognised by global investors- and acted on. It is clear that the US economy has yet to definitively find the bottom of its growth slowdown. However, investors are by-and-large reluctant to move their capital to alternative investment destinations. Nevertheless, there are some signs that the NZD is creeping back onto the radar screen. In addition, across the Tasman there are signs that the Australian economy is turning the corner, and Australia is beginning to receive greater investment interest as a result. If the Australian dollar rises on the back of this, the NZD is likely to benefit substantially as well.

Article from Westpac Trust - Quarterly Economic Overview