The Reserve Bank folk might be wishing they hadn't effectively locked themselves in to cutting interest rates this week

The Reserve Bank folk might be wishing they hadn't effectively locked themselves in to cutting interest rates this week

By David Hargreaves

Damned if you do and damned if you don't, I suppose.

The Reserve Bank, having recently moved on from making some poor judgements in how it communicated interest rate moves to the market late last year and earlier this year, may just at this moment be regretting the transparency with which it has approached this Thursday's official call on interest rates.

Our central bank has, in it's inimitable raised-eyebrow manner, gone about as far as it ever would in communicating to us that interest rates, via the Official Cash Rate, will be moved to a new historic low of 1.75% on Thursday from the current 2%.

The marketplace is always very happy when the RBNZ gives reasonably clear signals ahead of time as to what it's thinking of doing. This avoids volatility and market participants 'misreading' the market.

'Some incidents'

There were some notable incidents toward the end of last year and early this year when the central bank made extremely unwise efforts to put a floor on the OCR.

Perhaps most infamously was last December when the RBNZ, as the market expected, cut the OCR to 2.5%. But, as the market didn't expect, our central bank then accompanied this cut with forecasts and a commentary that as good as said it was done with any more cuts. Which was and remains an extraordinary thing to have done under the prevailing market conditions.

So, after some similar misadventure earlier this year, our central bank has recently been 'good' - maintaining clear, consistent messages and pointing the market in the correct direction.

This being the case, I've personally got no problem at all with the way the RBNZ has signposted a cut this week. Sensible and practical in fact. But what I would say is, that the very fast-changing environment is NOW suggesting a cut this week is probably the WRONG thing to do.

Anything can happen

Last week's low (4.9%) unemployment figures pointed to an economy moving ahead nicely and with some capacity constraints possibly emerging. The RBNZ's own survey of inflation expectations, which it keenly watches, showed an uptick in inflation expectations. The US Presidential election could probably be best titled: 'Expect Anything'. And then what to make of the boo-boo Statistics New Zealand made with the September inflation figures?

I guess perspective is needed and at 0.4% the real/corrected annual inflation figure is very low against a virtually non-existent 0.2% under the old erroneous calculations.

However, it is worth considering that the original 'error' figure was in any case actually somewhat higher than economists had predicted. So the 'real' one will be quite a bit higher than expected.

Also, the non-tradeables annual inflation rate jumps from 2.1% in the incorrect version to 2.4%. Again quite a difference.

Mind your language

I'm not sure what the standard of spoken language is like inside the RBNZ offices, but I would have certainly forgiven them for coming out with a bit of fruity stuff when those new figures got dumped on them.

The RBNZ of course has to produce a new set of economic forecasts including, most importantly of all, new inflation forecasts in the Monetary Policy Statement to be issued in conjunction with the OCR review on Thursday.

It is going to be reasonably interesting, to say the least to see if: A/ It will have time to incorporate the revised CPI figures into its forecasts and B/ What it says about the likely impact of those changes.

I've had a sneaking feeling for a little while that inflation is going to start surprising on the upside.

Leave it alone

What the tea leaves are now seemingly telling us is that it would probably be best to leave the OCR right where it is just at the moment.

And I haven't even tried to quantify the impact of a Trump Presidency. That way madness lies.

The prime motivation behind a cut to 1.75% this week is the strength of the New Zealand dollar. Our currency has once again developed wings and flown above US73c.

If the RBNZ didn't cut this week then the Kiwi could be expected to fly still higher.

A murky picture

There are complications with this picture as well though.

One complication is very much of the RBNZ's own making. It has changed the timetable for OCR decisions. There used to always be an OCR call in December. Now, this year, the OCR review this week will be the last till February 9 - basically three whole months. A LOT is likely to happen in that time. Maybe the RBNZ is now having some room for regret on that decision as well.

And another complication is that for the first time in this Monetary Policy Statement the RBNZ will start giving us its explicit forecast of where it sees the OCR being set in future as part of the economic forecasts over the next couple of years.

It's a sensible move. Previously the RBNZ gave estimates of where it saw the 90-day bank bill rate heading. But this of course was effectively a bit of a sleight of hand, guessing game, since the bill rates are largely based on the OCR, the level of which is the Reserve Bank.

No more guessing

So, now the guessing game's gone. But it does now pose a different challenge for the RBNZ. If we assume that the planned cut to 1.75% by the RBNZ this week was seen as likely its last for the foreseeable future, would it tell us that? Do we look at projections of the OCR for the next year and see '1.75%'. If that's the case, then the dollar will likely go up for sure and the effect of the cut will be completely nullified, much in the same way as it was in December last year when a cut was accompanied by very positive, hawkish, commentary indicating no more cuts.

The upshot is don't make an OCR cut and the dollar will go up - but very possibly it will go up in any case, particulary given the constraints of the new requirement to predict the OCR level directly.

So, dilemmas all round.

Hold fire after all?

With everything else that's going on, is it just possible the RBNZ may yet hold fire on a rate cut this week and leave itself some leeway for future OCR decisions?

It would be a brave move and the central bank would cop it in the neck from the market place given that it would be a complete U-turn on the way the RBNZ has led the market.

But, do you know, it just might be the right thing to do.

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Thankfully, those in possession of capital to trade take absolutely no notice of what central bankers say.

One wonders whether the OCR has relevance anymore. Take a look at the yields on Government and Corporate Bonds since September - all are trending up. Likewise the exchange rate - NZ$ strengthening against most major currencies.

The banks may use any OCR cut as an excuse to drop deposit rates but given their concern around the housing market I suspect they'll be fighting each other to hold on to what deposits they have.

Tom deposit rates won't drop a point, indeed could even go up a bit on Thursday - but the one thing that is for certain is that mortgage rates will not go do

The OCR is not relevant anymore the same way inflation data is meaningless.
The most expensive asset a family is ever likely to buy, a house, is not in the inflation figures.
Surly this distorts any measurement of inflation.
Until all prices and not just a select few are included, then inflation data means nothing to the ordinary man in the street buying a house.

Perhaps New Zealand needs one of these...then we can compare how we stand..individually.

Thanks Kiwimm for that. It is not quite as comprehensive as Yanks one...But a telling story, none the less. Some people must owe a great deal. wonder they want to import more issues.??.

Well said David - we will know for sure on Thursday!
A question to pose to the audience - why do WE want inflation? Yes I get it that the Govt does, to increase the tax take, but for anyone else - its a pain to manage, distorts asset pricing and erodes worker incomes.

As a lay person in such things I have often wondered the same, never seem to get a definitive answer? Spending causes inflation which stimulates the economy etc etc etc but at this time when we are told inflation is practically non existent it seems to me consumer product prices are heading up just fine? Anyone renovated recently! And then we are told we are the worst savers in the world, we can't spend to stimulate the economy and save at the same time?

The reason WE want inflation is actually not immediately obvious. But it is because we need inflation (read wage inflation) to reflect ever higher ENERGY input costs into the economy. Energy is the economy and we are fighting diminishing returns in terms of the energy cost in obtaining it.
If you think of it from a producer point of view, the (uncontrollable) cost base of producing a product is continually rising. Unless we have sufficient inflation, producers have to out perform diminishing returns (typically by chasing economies to scale) just to stay afloat.

Not sure WE do want inflation. It works well for the banks as it encourages taking on debt as you can buy at today's prices and pay back in inflated dollars.

Trouble now is that the global economy is sitting on record levels of debt and teetering on the edge of deflation. In spite of CB's best efforts there is not much sign of inflation in consumed goods although they have pumped up a massive ponzi bubble in assets such as property and shares.

They'll use lots of excuses about "needing to generate inflation" but I'm convinced the real reason for keeping rates at record lows is the world is swimming in debt and they're trying to prop up the ponzi. With respect to the future direction of rates Mr Market appears to have different ideas to that of Central Bankers.

See comment above - you are right about why interest rates cant go up - there is too much debt in the Ponzi. But it is there for a reason - to keep commodities supplied ... because debt helps elevates commodity prices (by stimulating demand). The alternative (and guaranteed future) is logically a really ugly option...

I will go into this topic in more detail next week, but 43 million of our citizens live in poverty. Fifty-six million are enrolled in Medicare. Almost 43 million of our citizens receive food stamps. We have lost 5 million manufacturing jobs in the last 16 years. Median income is up just 3% in the last 16 years, while the median new home price has almost doubled. Ninety-four million people are not in the workforce, with 15 million of them actually unemployed (though the official number is only 8 million).
It is quite conceivable that we could be approaching $30 trillion in national debt by the time the president is inaugurated in 2021. Make whatever assumption you want to about interest rates, the level of taxable revenues in current models suggests that interest could easily be consuming more than 15–16% of revenues by then. And growing…

That is not a sustainable model.

Ideally we don't want inflation. In an ideal market we would also never experience sustained positive or negative inflation.
However, it is a necessity in any environment where there is no condition of perfect inelasticity (i.e. supply cannot react perfectly to demand conditions).
So, on the basis of this we opt for a positive net inflation of goods in as the lesser evil of inflation or deflation. The reasoning for this, fundamentally, is to ensure a positive level of demand within a system. It essentially incentivises producers in the medium term and consumers in the short term. The counterfactual is that in an deflationary position, producers are incentivised to produce less in the short to medium term as consumers are rewarded for saving in the longer term. Obviously this position perpetuates itself period on period, making things very bad.

The counterfactual is that in an deflationary position, producers are incentivised to produce less in the short to medium term as consumers are rewarded for saving in the longer term. Obviously this position perpetuates itself period on period, making things very bad.


Thus, the decline of interest rates to zero corresponds with a monetary imbalance in favor of deflation, if at least an abundance of deflationary pressures. This is something that Milton Friedman also talked about, particularly in 1998 with regard to Japan. He called it the interest rate fallacy, meaning that low nominal interest rates signify "tight" money conditions, or what would be consistent with significant deflationary pressure. It is and remains a fallacy because economists like those at every central bank around the world have decided instead that low rates are only "stimulus."

To correct this view, Friedman pointed out the basic, non-trivial distinction between a liquidity effect and an income effect. Low rates can be stimulative in the short run (the liquidity effect), but over the long run their persistence means something far different. A yield curve is supposed to be upward sloping given the core time value of money and investing. That arises from opportunity cost, meaning the more plentiful the opportunities the greater the time value and the steeper the curve (the income effect). Yield and/or money curves (the eurodollar curve and even the history of the OIS curve) that collapse and remain that way unambiguously demonstrate that "stimulus" deserves only the quotation marks. Read more

The question addressed was not about optimal interest rate policy, directly, but fundamentally what inflation is and why we target positive inflation.

But, yes, Friedman had a valid position.
His alternatives would be equally dubious in the current climate, too, however.

I know it's easy to say "told you so", for weeks I've been advocating NOT to cut the OCR because:
- it won't stimulate spending (the banks are not passing the cuts on)
- it won't lift inflation
- it won't lower the NZ$
But it will be extremely difficult to raise the OCR back to normal levels in the future because of the massive amount of personal and government debt
I have even written to MrGraham Wheeler

I told you so

The RB will make the best decision they can with regards to raising, decreasing or leaving the OCR - and without doubt this decision will sort out all of the housing issues in Auckland.

And I am the Bitch Queen of Ruritania.

They can have surprise decisions, and have in the past. As it excluding property, and that has had huge inflation over the last few years, these cuts are somewhat irrelevant in terms of reducing inflation and reducing the NZD. Instead they just fuel the property prices, as people can afford to service bigger mortgages and thus pay more. People will tend to borrow up to their limits when there is poor supply.

Call me crazy, but if one's proposed course of action has been revealed to have been based on inaccurate data, surely the prudent thing to do is re-consider that course of action?

What happend to DTI

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