This week's decision on interest rates needs to somehow combine market expectation and what the NZ dollar might do with doing the 'right' thing

By David Hargreaves

To the best of my knowledge Graeme Wheeler has never been a gymnast, juggler or acrobat - though I gather he was a more than useful cricketer.

The Reserve Bank Governor will need to be a bit of all those things in this week's normal six-weekly review of official interest rates (IE show strength, dexterity and agility and don't give the delivery too much of a tweak) as he struggles to produce a decision that will keep 'the market' satisfied and on an even keel.

You see, this country is currently in a strange place with its interest rates. We've got them wrong.

It is a debateable feast, but I would certainly argue that our Official Cash Rate, at 3.5%, is around one whole percentage point too high. And interestingly enough, one whole percentage point is how much the RBNZ raised rates between March and July 2014 to counter a spectre of future inflation that subsequently disappeared into the ether.

As I have opined previously, those rate hikes last year can now be viewed as a mistake. I hastily add that I didn't think it was a mistake to put rates up at the time, and I can't recall many if any economists saying it was.

The trouble is, the RBNZ can't just teleport itself back in time and magically unwind those rises to give us the 2.5% we should have. It would have to physically now climb in and drop the rates. And strangely, even though the rates may be one percentage point too high, dropping them by that much would send all sorts of incendiary messages to the market. Not least affected of course would be the Auckland house market. Did somebody say incendiary?

Sending a signal

It is all about signals. The 'market' hangs off every nuance the RBNZ gives out. "Did the Governor raise one eyebrow then, or both? And what does both eyebrows raised mean?"

Send the wrong signal, albeit inadvertently, and the market will put 2+2 together to produce 22. And then it's all on.

Growing numbers of economists have been picking that the RBNZ will drop interest rates. In fact some of these predictions have almost amounted to calling on the central bank to drop rates, which is interesting. The ANZ in particular has been quite strident and is again this week pushing for a rate reduction ahead of releasing its latest monthly inflation gauge on Tuesday. Yours truly presumes the latest gauge release will again show falling inflation, backing up ANZ's claim for an imminent need for rate cuts.

What it all means is that Thursday's interest rate call by the RBNZ is very much "live" in the sense that the market is asking: Will it, or won't it? This is the first "live", "will it or won't it?" OCR decision since the last rate hike was made in July last year.

I'll be gobsmacked

Personally, I will be gobsmacked if the RBNZ does cut rates on Thursday - even though, as I've just said, I think rates are too high.

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.

Logic would suggest that the RBNZ would want to give itself a bit of breathing space between declaring a move toward an easier stance on rates and actually easing rates.

Then there's inflation. We know this is looking benign at the moment - 0.1% being about as benign as it gets before you get into deflation. But regardless of what ANZ comes up with this week in terms of its inflation gauge, the RBNZ's most recent inflation expectations survey in May showed an uptick in expectations - albeit very slight and from low levels. So, that would be a reason for the RBNZ to pause.

Naughty Auckland

Then there's that Rebel Without a Cause, which calls itself the Auckland house market. It is 'hot right now'.

The RBNZ and the Government (the latter very late to the party, but nevertheless, welcome) have both unholstered weapons and aimed them at Auckland. But as is the nature of these things, the physical start date for this 'pincer movement' is October 1. The RBNZ would surely want to get closer to that date before moving interest rates down. Why pour petrol on the fire now when you've previously announced that the fire engine won't be on the premises till October 1?

But what about the dollar? The ANZ and others have been very keen to cite that as a reason for moving rates now.

And we do need a lower dollar in the face of what is now clearly an economy past its peak and with some sectors - notably dairy - really starting to struggle.

Dollar dips

But it is worth stating that as I write this, the Kiwi dollar is since April 30 (the day on which the RBNZ announced a move to an easing bias and Fonterra dropped its milk payout forecast) down nearly 9% against the American currency and around 6% on the trade weighted index. The inflationary impact of such a fall can hit quite quickly through higher import costs - and the RBNZ needs to be mindful of that.

There's no doubt that markets are betting that the RBNZ will move rates down this week. The key question then becomes what would the NZ dollar do if there's no move by the central bank? Might it rise strongly?

But to flip that one around, let us just suppose the RBNZ did drop interest rates on Thursday, and what the heck, why not whack 50 basis points off them? The market reaction may well be "okay that's done, fine" and then perhaps start looking for reasons for the dollar to go up again! You never can tell, but maybe.

If on the other hand the RBNZ makes clear it is looking at rate reductions - but doesn't do it - then this will hang over the market. In this instance the threat of a reduction might (providing the market believes it will be followed up on) be more effective than the actual move.

So, waiting now and moving later could be advantageous. And there might be something else the RBNZ could throw into the mix here too.

Sell those dollars

As we know, the central bank's not that keen to intervene in the currency markets (given that there are some individuals in this world who could cause this country to lose its collective shirt if they decided to have our central bank on), unless it feels it can be effective. In the past the RBNZ has tended to only sell substantial amounts of NZ currency at times when it feels the Kiwi dollar is looking 'toppy' and can be pushed over the edge.

I would speculate we are now approaching one of those times. Don't be too surprised if the RBNZ doesn't offload a few wads of Kiwi cash in the coming weeks.

I'm sticking with my pick that our Official Cash Rate will be 3% by Christmas. Previously I had suggested the first move would be October. I will now bow down to common opinion and suggest that the first move is probably likely to be September. There's a logic to doing it then because the September rate call is in conjunction with a full Monetary Policy Statement - and the RBNZ generally prefers to start a rate cycle with the accompaniment of a full explanation (though that is by no means a hard and fast rule).

But of course. I don't know. Only our acrobatic, juggling, gymnastic ex-cricketer of a Governor and his trusted lieutenants know.

One thing I would say as a parting shot: If the RBNZ does cut this week - less than two months after acknowledging that cuts might realistically be on the table - then it would be an indication that the economy is weakening rather more quickly than has been widely believed.