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It all comes down to the inflation target: BNZ's Toplis

Wednesday 13th March 2019

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If the Reserve Bank of New Zealand were to adopt the Reserve Bank of Australia’s inflation target, “we should be considering easing relatively aggressively,” says Bank of New Zealand's head of research Stephen Toplis.

The RBNZ’s inflation target is 2 percent, the midpoint of its 1-3 percent range while the RBA’s target is 2.5 percent.

Conversely, Toplis says that if the RBA adopted the RBNZ’s target, “there would be very little argument for a rate cut in Australia.”

Financial markets have fully priced in the likelihood the RBA will cut its cash rate by September and a 50 percent chance of another cut by the end of the year.

The market has priced in a 70 percent chance of an official cash rate cut in New Zealand within the next 12 months.

“That a small change in the inflation target could have such a wide-ranging impact on monetary conditions and the overall prospects for an economy is rather disconcerting and again questions the efficacy of inflation targeting in its current form,” Toplis says.

There probably isn’t a “right” target, but currently Australia is nearly a percentage point away from its target while New Zealand isn’t far off the RBNZ’s target.

Inflation in Australia in calendar 2018 was 1.8 percent while it was 1.9 percent in New Zealand.

“At the moment, interest rates are not having a major impact on inflation pressures globally – either raising them or lowering them might not make a big difference,” Toplis says.

But if the market is correct and the RBA does cut its cash rate soon, it’s possible the RBNZ will follow suit, “but it doesn’t have to,” he says.

An argument in favour of a rate cut in Australia is that growth appears to have lost significant momentum, as Toplis’ colleagues at National Australia Bank have written.

There’s evidence of a similar pattern in New Zealand with GDP in the year ended September 2018, the latest available data, slowing to 2.6 percent from 3 percent a year earlier and 4.1 percent the year before that.

“Moreover, we expect further declines in the annual reading through to June 2019. This does place at risk further tightening in the labour market but New Zealand’s labour market is already stretched to breaking,” Toplis says.

“Skill shortages are rife and a lack of labour availability is acting as a serious constraint on growth.” With the unemployment rate at 4.3 percent, the Reserve Bank has said employment is “near its maximum sustainable level.”

Australia’s is somewhat higher at 5 percent, although there are arguments that’s still so low that it’s effectively full employment.

However, New Zealand’s labour market participation rate at 70.9 percent of the working age population “is miles ahead of Australia’s 65.6 percent,” Toplis says.

While house prices have fallen sharply in Sydney and Melbourne, they’re still rising in New Zealand, although prices in Auckland and Canterbury have shown “a modest correction.”

In Australia, there is significant evidence of a tightening in credit conditions but there’s limited evidence here.

“Putting this all together, we see no reason to believe any cut in interest rates by the RBA would necessitate the RBNZ following suit.”

That’s barring some major shock, such as a drought, which looks unlikely or some external shock, which is always possible.

Nevertheless, there is a chance that any further softening in the Australian economy, New Zealand’s second largest export market, could impact New Zealand growth.

“But before this impact can have a meaningful effect on domestic monetary settings, New Zealand would have to satiate the current excess demand for both labour and housing,” Toplis says.

“Given that this will take some time, we would argue that any Australian downdraft would be felt with a relatively long lag,” making it much more likely the RBNZ would respond next year rather than this year.


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