The Reserve Bank cuts Official Cash Rate to 3.25% from 3.5%

The Reserve Bank has dropped the Official Cash rate to 3.25% from 3.5% - the first lowering of interest rates since March 2011 and following four rate hikes last year.

The latest decision outlined in the bank's Monetary Policy Statement was something of a surprise. It had been seen as a 'line call' by economists with several expecting a cut and slightly more expecting a "hold" decision.

The RBNZ has factored another potential cut of quarter of a percentage point into its forecasts over the next year.

Dollar drops

The Kiwi dollar, which had been pushing up against US72c, immediately dropped to US70.6c. Against the Australian dollar it dropped to A91.2c from A92.8c. Later in the day the Kiwi was sitting just above US70c. It was briefly last below US70c on September 1, 2010. Stronger than expected employment figures across the Tasman pushed the Australian dollar up and as of Thursday evening the Kiwi had declined to A90.4c, with all thoughts of parity vanished.

Both ASB and Kiwibank immediately announced drops in their floating mortgage rates after the RBNZ decision, followed a short time later by the ANZ, New Zealand's largest bank, which has argued stridently for the RBNZ to cut rates.

Banks move on rates

Kiwibank has reduced its variable and revolving rates from 6.65% p.a. to 6.40% p.a. with the reduction to take place immediately for new customers and in two weeks for existing. ASB dropped its variable home loan and Orbit home loan rates by 0.25bps from 6.75% p.a to 6.50% p.a effective 8am Friday 12 June for new customers and 8am Friday 19 June for existing customers. ANZ is lowering interest rates on its Floating and Flexible home loans by 0.25% p.a. – to 6.49% for ANZ Floating Rate Home Loans, and 6.60% for Flexible Home Loans. The new rates will take effect for new ANZ Floating Rate Home Loan customers from Monday 15 June, and for all existing Floating Rate and all Flexible Home Loan customers from Monday 29 June. See full details of bank rate cuts here.

The RBNZ has clearly become extremely concerned about the impact of falling dairy prices. In its latest Financial Stability Report last month, the RBNZ warned that financial stress in the dairy sector "could rise markedly" if prices remain at low levels in the 2015-16 season. The RBNZ says that despite many farms being in a position to manage down working expenses, around one-quarter of dairy farms are believed to have had negative cash flow for the 2014-15 season.

Just yesterday, dairy giant Fonterra announced it was likely to shed "hundreds" of jobs from its head office and support functions.

Commodity price problems

Governor Graeme Wheeler said in announcing today's rates decision that the fall in export commodity prices that began in mid-2014 "is proving more pronounced".

"The weaker prospects for dairy prices and the recent rises in petrol prices will slow income and demand growth and increase the risk that the return of inflation to the mid-point [of the 1-3% target] would be delayed."

In the MPS document the RBNZ has drastically revised its expectations of the terms of trade, picking them to fall 8.4% in the March 2016 year and then climbing just 0.1% the following year. In its March forecast, the bank expected terms of trade to be just 3% lower in 2016, before gaining 1.4% in 2017. Terms of trade measure the value of imports that can be purchased by a set amount of exports.

Wheeler said with the fall in commodity prices and the expected weakening in demand, the exchange rate had declined from its recent peak in April, but remained overvalued.

"A further significant downward adjustment is justified. In light of the forecast deterioration in the current account balance, such an exchange rate adjustment is needed to put New Zealand’s net external position on a more sustainable path."

Kiwi dollar 'over-valued by 7%'

Asked this morning about where he felt the NZ dollar should be in terms of a sustainable value, Wheeler said the RBNZ always avoided doing that. However, he cited some Peterson Institute for International Economics research in May, which indicated the Kiwi dollar was over-valued by about 7% "but they wouldn't have built in the latest dairy and commodity prices". 

This is what Governor Wheeler had to say in his statement:

The Reserve Bank today reduced the Official Cash Rate (OCR) by 25 basis points to 3.25 percent.

Growth in the global economy remains moderate. Data on economic activity in the US, China and Australia has been mixed, although there has been some improvement in the euro area and Japan. Volatility in financial markets has increased.

The New Zealand economy is growing at an annual rate around three percent, supported by low interest rates, high net migration and construction activity, and the decline in fuel prices. However, the fall in export commodity prices that began in mid-2014 is proving more pronounced. The weaker prospects for dairy prices and the recent rises in petrol prices will slow income and demand growth and increase the risk that the return of inflation to the mid-point would be delayed.

Inflation has been low due to falling import prices and the strong growth in the economy’s supply potential. Wage inflation and inflation expectations have been subdued.

With the fall in commodity prices and the expected weakening in demand, the exchange rate has declined from its recent peak in April, but remains overvalued. A further significant downward adjustment is justified. In light of the forecast deterioration in the current account balance, such an exchange rate adjustment is needed to put New Zealand’s net external position on a more sustainable path.

House prices in Auckland continue to increase rapidly, and increased supply is needed to address this. The proposed LVR measures and the Government’s tax initiatives planned for 1 October 2015 should ease the impact of investor activity.

A reduction in the OCR is appropriate given low inflationary pressures and the expected weakening in demand, and to ensure that medium term inflation converges towards the middle of the target range.

We expect further easing may be appropriate. This will depend on the emerging data.

This is a report from BusinessDesk's Paul McBeth on the rate cut:

June 11 (BusinessDesk) - The Reserve Bank cut the benchmark rate a quarter-point and signalled more may be on the way as the dairy sector's weak outlook weighed on the nation's terms of trade and threatened to delay an increase in inflation from its near-zero level. The New Zealand dollar dropped almost a cent.

Governor Graeme Wheeler lowered the official cash rate to 3.25 %, in a closely watched decision where markets were largely split on whether he would cut rates now or later, saying a more pronounced slump in export prices than expected and the prospect of waning consumer demand on increasing petrol prices threatened to keep a lid on already low inflation.

“The weaker prospects for dairy prices and the recent rises in petrol prices will slow income and demand growth and increase the risk that the return of inflation to the mid-point would be delayed,” Wheeler said in Wellington. “A reduction in the OCR is appropriate given low inflationary pressures and the expected weakening in demand, and to ensure that medium-term inflation converges towards the middle of the target range."

"We expect further easing may be appropriate."

The bank expects the country's terms of trade will be about 5% lower than in its March projections, primarily on the sharp decline in dairy prices, which suggested monetary policy needed to be more stimulatory to stoke inflation back into the target range of 1-3% annually.

Before the announcement, traders had been pricing in a 40% chance Wheeler would reduce the benchmark rate for the first time since the March 2011 emergency cut in response to the Canterbury earthquake.

Persistently low inflation, compounded by a strong New Zealand dollar, prompted some analysts to question why Wheeler hadn’t cut, and the view gained momentum after the Reserve Bank and government both unveiled responses to try and cool Auckland’s housing market.

Wheeler had already dropped his reference to the possibility for interest rates to rise at the April review.

The central bank lowered its track for the 90-day bank bill rate, often seen as a proxy for the OCR, seeing it fall to 3.3% in the December quarter of this year, and bottoming out at 3.1% in June 2016 where it stays over the bank's forecast horizon until June 2017.  In its March forecast, it predicted the rate would stay at 3.7% through to March 2017, the end of the forecast horizon.

New Zealand’s consumers price index rose a 0.1% in the year ended March 31, after two quarters of contraction kept a lid on inflation. That’s below the central bank’s target band for inflation to be between 1% and 3%.

The central bank expects annual inflation to rise more aggressively on a weakening exchange rate and increasing petrol prices. The bank forecasts annual CPI will advance to a 1.6% pace by March next year, before reaching 2.1 percent in December 2016.

The trade-weighted index was at an average 75.96 in the March quarter, below the Reserve Bank’s projected level of 77 in the March forecast, and the central bank sees the TWI gradually declining to 71.4 over the horizon.

Wheeler dropped his reference to the kiwi dollar being unjustifiably and unsustainably high, explicit criteria for the central bank to intervene in foreign exchange markets, saying it was still overvalued  and "a further significant downward adjustment is justified."

The slow recovery in global dairy prices and peak of the Canterbury rebuild has seen some optimism over the pace of the nation’s economy taper off in recent months, and the Reserve Bank stripped out about 0.5 of a percentage point from its forecast economic growth in 2016 and 2017 March years.

The central bank moved toward an easing bias on interest rates only a little more than a month ago, first in a speech by assistant governor John McDermott and then backed up a week later on April 30 in the last OCR announcement.

Those rate hikes last year can with the enormous benefit of hindsight be viewed as a mistake. Inflation pressures that the RBNZ believed would start to surface were washed away by unpredictable counter-inflationary pressures such as the massive fall in oil prices and continued high New Zealand dollar.

Growing numbers of economists had been picking that the RBNZ would drop interest rates. In fact some of these predictions almost amounted to calling on the central bank to drop rates, which is interesting. The ANZ in particular has been quite strident and was again this week pushing for a rate reduction.

But the RBNZ had been cautious in the face of a very hot Auckland housing market, mindful that dropping interest rates quickly could provide more fuel for the housing market.

The RBNZ and the Government have both announced measures and aimed at the overheated Auckland house market, with a given start date of October 1.

But in the meantime the Auckland market has shown no signs of slowing.