Wheeler risks failure in trying to weaken kiwi dollar with rate cuts

See also: Wheeler Watch: will the Reserve Bank surprise the markets?

Reserve Bank governor Graeme Wheeler achieved diminishing returns from cutting the official cash rate four times last year when the trade-weighted index stopped falling in September, putting a line under his ability to encourage imported inflation.

Economists and traders expect Mr Wheeler will keep the OCR at 2.5% this week but bets on the decision have narrowed, with a 56% probability of no change and about 44% odds he will cut, based on the overnight interest swap curve. He is expected to make at least one quarter-point cut this year, even though he has argued against a knee-jerk response to annual inflation that was just 0.1% in 2015, the lowest since 1999.

The trade-weighted index was recently at 73.01, or about 5% below the level the central bank projected on average for the first quarter in its December monetary policy statement. A stubbornly high kiwi dollar is one of the reasons, along with the decline in crude oil prices, that New Zealand faces no inflationary pressures from offshore. Tradables inflation shrank 1.8% in the fourth quarter, for a 2.1% annual decline.

Last month's Reserve Bank Survey of Expectations shows respondents see annual inflation one year out at 1.09%, down from the 1.51% rate seen in the last survey three months ago. Expected inflation in two years' time has been lowered to 1.63% from 1.85%, the lowest expectations for prices in more than 20 years.

The December Monetary Policy Statement projected annual inflation to undershoot the 2% midpoint of the central bank's 1-3% target range through until December 2017 but Finance Minister Bill English doesn't plan to revisit the policy targets agreement until the official review next year, saying the bank has got "a fairly difficult problem" because interest rates are already at 50-year lows, the economy is trucking along well and the Policy Targets Agreement with the Reserve Bank is deliberately flexible to allow Mr Wheeler to look through temporary phenomena such as the drop in crude oil prices.

"We do think inflation will move up toward 2% over the next couple of years ... but we would have more confidence in that view if the exchange rate was lower," said Darren Gibbs, chief economist at Deutsche Bank. "That said, our own view is that the Reserve Bank would probably need to cut the official cash rate by 150 basis points or more to achieve the material change in the exchange rate that it would clearly prefer and that would deliver a materially stronger near-term profile for inflation."

In a February 3 speech, Mr Wheeler singled out slower growth in China, which accounted for 40% of global growth in 2014, as the biggest risk to New Zealand and the global economy, while also noting impetus to the local economy from cheaper oil, strong inbound migration and tourism, while weak dairy prices constituted another economic risk. That same day, government figures showed the jobless rate fell to the lowest in almost six years, while employment grew faster than expected.

The Reserve Bank has forecast gross domestic product grew 0.6% in the fourth quarter. Bank of New Zealand head of research Stephen Toplis is forecasting 0.7% growth, which he said was "hardly reflective of an economy in need of extra stimulus."

"Normally, central banks cut rates to stimulate demand," he said. "The rationale for this, currently, is weak."

China, New Zealand's biggest trading partner, lowered its economic growth forecasts at a political summit at the weekend. Premier Li Keqiang told the National People's Congress parliament that the target for growth was now 6.5% to 7% for 2016, after growth in 2015 undershot the target of 7%. At the same time, Chinese leaders stressed that they don't expect a hard landing for the world's second-largest economy.

In keeping the OCR at 2.5% on January 28, Mr Wheeler said some "further policy easing may be required over the coming year to ensure that future average inflation settles near the middle of the target range." He gave more guidance in last month's speech, saying a cut could be needed "if concerns deepen around the prospects for the global economy and its impact on New Zealand."

(BusinessDesk)