New Zealand's Turn

October 21, 2008

The Bank of Canada eased monetary policy earlier today. Tomorrow at 20:00 GMT (09:00 on Thursday locally), the Reserve Bank of New Zealand will reduce its cash rate for the third time within three months. Markets look for a 100-bp cut, although a reduction of 75 basis points is possible. Until July 24th, a cash rate of 8.25% was the highest within the OECD. That peak level had been maintained for a full year and followed four increases of 25 basis points in 2007, three of the same size in 2005, and six in 2004.Three cuts totaling 75 bp were made in 2003 after four hikes in 2002. The cyclical low prior to March 20, 2002 had been 3.75%. The first cut this year was by 25 basis points and was followed by a second reduction on September 11.  That one’s size of 50 basis points surprised analysts, who assumed another move of 25 basis points.

Back in September, RBNZ monetary authorities predicted that CPI inflation would peak at 5% in 3Q08, average 4.7% in the second half of this year, and then recede to 3.2% by 2H09 and 2.8% by 2H10.New Zealand has stagflation. Only in 2010 did officials expect in-target inflation to get restored. The statement from the September meeting also spoke of a prolonged period of weak consumption and sub-trend economic growth. Additional scope remained for reducing rates, but the path would be influenced by how inflation evolved and the relative weakness of the New Zealand currency, known as the kiwi. Initially, analysts concluded that the likely size of a fourth rate cut in October would be 25 basis points, but that estimate quickly got bumped higher after the failure of Lehman and subsequent intensifying rupture of world financial markets. In the meantime, a second consecutive quarter of mildly negative GDP growth was reported in New Zealand, led by consumption, housing, and net exports. New Zealand housing has been hammered, and real estate values show a 12-month drop of about 6%.  A surprisingly brisk uptick in business investment in 2Q08 appears unsustainable, and the consensus coming into this week had been that the New Zealand cash rate would be lowered this time by a whole percentage point to 6.5%.

The two constraints on easing that were cited in the September statement both suggest that monetary officials may instead slash their benchmark rate by 75 basis points. The kiwi has fallen 5% since the September meeting, and third-quarter consumer price inflation was a shade worse than expected. The total CPI went up 1.5% last quarter, lifting its 12-month pace to 5.1% from 4.0% in 2Q08 and 1.8% in the year to 3Q07. Food prices posted a smaller quarterly increase of 0.6% but were 10.8% higher than a year earlier. Non-tradable goods rose 1.3% last quarter and 4.1% y/y, whereas prices for tradables suffered from the impact of the depreciating kiwi (down 25% since late February) and recorded a 6.3% on-year jump versus a 0.3% dip in the year to 3Q07. Officials have not forecast a severe recession, and business sentiment improved unexpectedly in both August and September. Activity probably will stay in the red in 2H08, and New Zealand has considerable leeway to reduce short-term rates without having them drop below inflation. Moreover, New Zealand did not participate in the round of interest rate reductions earlier this month. A cut of 75 basis points would only match the Bank of Canada gross rate reduction in October and from a much higher level. The forecast of a 100-bp move therefore retains considerable plausibility.

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