Reserve Bank of New Zealand Does First Ease

July 23, 2008

New Zealand’s cash rate was cut to 8.0% from 8.25%, a level that had been in force for 12 months.  This easing was considered possible by market analysts but much less probable than a reduction in September.  The cash rate was last reduced in July 2003.  From a 5.0% level after that, there had been 13 increases of 25 basis points each, six in 2004, three in 2005, none in 2006 and four last year to a record high of 8.25%.

A statement released today by the central bank said more unpleasant international news had emerged since midyear, creating a “risk that the domestic economy will slow further.”  Many private analysts are predicting a recession in New Zealand among other developed economies like Italy, Britain, Japan, Spain and the United States.  Although the Reserve Bank cited some factors that will support growth, such as high export prices and expansionary fiscal policy, it said monetary conditions had tightened recently as a result of the international credit crunch and justified a reduction now on the grounds that it “will help to mitigate the effect of these increases on the actual borrowing costs paid by firms and households.” Such an argument could be used by most central banks, but so far only four have cut rates — the Fed, Bank of Canada, Bank of England and now Reserve Bank of New Zealand.

At a rate of 8.25%, it was not risky for this action in New Zealand.  But at the ECB, where the 4.0% refinancing rate is at par with on-year inflation, or at the Bank of England, where inflation may yet climb to the 5.0% bank rate, officials are much less likely to cut rates as an offset to the credit crunch.

New Zealand monetary officials did their first ease before inflation had crested.  They expect annual CPI to peak around 5% in the current quarter but underscored that policy is guided by their outlook for medium-term inflation.  That outlook is influenced by three main factors.  First is economic activity, which will be weak through the rest of 2008 and constrained in 2009 by high oil prices and the ongoing housing slump, both of which will limit consumption.  The statement does not talk about anchoring expected inflation per se but indicates that weak growth will constrain wage claims and corporate purchasing power.  Historically, when expected inflation is creeping higher, a disconnection generally occurs between sub-potential growth and the downward pressure on inflation that otherwise occurs.  A second determinant of medium-term inflation is movement in the exchange rate, and a third is the future course of oil and other commodity prices.

The statement says that the cash rate will be lowered further unless 1) the kiwi depreciates excessively or 2) the outlook for inflation doesn’t continue to improve, meaning if growth turns out to be stronger than now assumed.  The statement does not make future easing contingent upon commodity price stability.  On a day that saw oil futures tumble another $4 or 3%, maybe that isn’t necessary to point out.  However, since 2003, oil has charted several huge corrective declines only to come roaring back to fresh highs.  If oil exceeds $150 per barrel anytime in 2009, I would think that would exert a constraint on New Zealand credit policy, and frankly that seems to be a more credible risk on the central bank’s freedom to cut rates than the possibility of substantial weakness in the kiwi.  But all of these hypotheticals are just contingencies.  The baseline policy plan now calls for a series of rate reductions, and from the new yet still very lofty level of 8.0%, it would appear that officials have plenty of room in which to operate.



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