In order not to kill our fragile economic recovery, the Reserve Bank's taken something of a calculated gamble that inflation will behave itself

There's definitely some risk attached to the approach the Reserve Bank (RBNZ) has taken in its first Official Cash Rate (OCR) decision of the year and accompanying Monetary Policy Statement (MPS).

The background to this decision was interesting. If we recall, late last year the RBNZ followed a jumbo 50 point cut to the OCR, with another 25 point cut in the decision on November 26. 

With the benefit of hindsight, it seems the RBNZ was, prior to the jumbo cut, thinking that it had about 50 points worth of cutting still to do. It went for the jumbo cut in October because of the clear signs the sought-after economic recovery was faltering and, well, people needed cheering up. They needed an excuse given to them to go out and spend some money.

Having used up its 50 points in one go then, the RBNZ was faced with the choice of either ending the cutting cycle there and then, which would have just seemed plain strange after a double-cut, or going ahead with another 25 point cut it reckoned we didn't really need.

So, it went ahead in November with the non-needed cut, but was reasonably clear that this one would be the finish.

The financial markets responded to that fairly definitive sign from the RBNZ by immediately looking for when the next RISE in the OCR might happen, and therefore wholesale interest rates surged, sufficiently that banks then felt they had to start raising mortgage rates.

This was, no doubt, a very surprising development just before Christmas and a rather rude way to send people off on their summer holidays.

Very odd situation then. Central bank drops the key interest rate, but monetary policy is effectively tightened.

The mortgage rate killer

And, while it's early days yet in terms of getting official economic data through for late last year and early this year, clearly those upward moves in mortgage rates were enough to get our hesitating economic recovery hesitating even more.

The housing market seemed to have been flattened by it in January, for example.

Financial markets were pretty much expecting the OCR to start rising again in September of this year. If the RBNZ had backed up that expectation with its new OCR 'forward track' projections in the latest MPS , then the financial markets would have probably reacted by pricing in an even earlier start to hikes. More upward pressure on mortgage rates might have ensued.

What the RBNZ has done in its projections (page 40) in the latest MPS, is give a just over 50% chance that the OCR will move up in the December 2026 OCR review, and an over 100% chance it will have risen in the February 2027 review. But only by 25 basis points. And then there's no aggressive portrayal of rises from there. The forecast timeframe ends in 2029, at which time the projection is for a 3.0% OCR. 

Some of the bank economists were, and I dare say still are, expecting more than that. For now though, the financial markets have backed off, and are now obediently pricing in the first OCR rise for December.

New RBNZ Governor Anna Breman, overseeing her first OCR review, was explicit in wanting to give the economic recovery every chance: 

We do see that we are in the early stages of an economic recovery. But it’s true that many households will not feel this yet. They’re still feeling the high inflation that we had over the past few years. Many businesses are still struggling,” Breman said.

But what we are seeing is that the data is showing us that we are at the early stages of a recovery and we want to keep the OCR on hold to support the recovery while ensuring that inflation falls back to target.

The alternative to this approach would have been to signpost OCR hikes - but at what cost to the recovery?

It could cut both ways

The reality is that there's risks both ways. Take what many regard as the 'prudent' approach, and signal hikes to counter inflation, and this could squash the recovery.

The approach that the RBNZ has taken - which as I said at the top is, I think, a calculated gamble, is to give that recovery the best chance of taking hold - but with the risk that inflation does overshoot. And as we saw in the wildness of the 2021-22 period, when annual inflation shot up from 1.5% to 7.3% - if this thing gets away on you, it can be hard to rein in.

An obvious question at this point, I guess, is why - when the RBNZ's mandate is to achieve 1% to 3% inflation - is it gambling on inflation getting away, in favour of giving the economic recovery a boost? Isn't it operating outside of its specific brief?

Well, of course there's another risk attached here, which is that if the RBNZ went all heavy handed with the OCR now, it could, by crushing the brittle confidence and therefore smashing the economic recovery, cause inflation to tank completely, below 2% - which is the RBNZ's explicit target.

So, in reality the risk with foreshadowing rate rises is that the central bank could cause inflation to undershoot its target, while the opposing risk is that by giving the recovery a chance and depending on inflation to behave...well, it could get away. Risks on both sides. Hey, this monetary policy stuff is not easy!

Inflation - you behave yourself - there's an economy at stake here

Therefore we are depending on inflation to behave. How are we doing on that score then? We know that annual inflation as measured by the Consumers Price Index (CPI) ticked up to 3.1% in the December quarter from 3.0% previously, putting it outside the 1% to 3% target range.

The first sneak preview of what might happen in the current (March) quarter was provided by the Selected Price Indexes (SPI) for January. It was a decidedly mixed bag.

The SPI includes around 47% of the ingredients of the CPI, but importantly, in terms of letting economists predict what the CPI outcome might be, it includes the more volatile bits of the CPI that are difficult to estimate.

The eye catching part of the latest SPI release was the 2.5% increase in food prices in January, the biggest rise in four years. That WAS offset though by still low rentals. lower power increases, a retracement of some of December's big rise in airfares and accommodation costs, while fuel costs came down again. 

The economists seem to be reckoning, based on this early indication, that the March quarter CPI might show an annual rate of inflation of 2.7% or 2.8%, which would of course get it back into the 1% to 3% target range. The RBNZ itself is forecasting 2.8%.

All things considered then, I think the RBNZ has taken the right approach. We do need to give the economy a chance.  

It's risky, but it's a risk worth taking.

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