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RBNZ's pathway to lower interest rates not too fast, not too slow: Wheeler

Tuesday 23rd August 2016

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Reserve Bank governor Graeme Wheeler has defended his approach to cutting interest rates, saying New Zealand's interest rate differential is too high to leave things as is, but a more aggressive stance ran the risk of destabilising the financial system.

In a speech written by Wheeler and delivered by assistant governor John McDermott to the Otago Chamber of Commerce in Dunedin, he said the bank reaffirmed its view that there are 35 basis points of further cuts expected for the official cash rate and that the emerging economic data will determine whether more or less is needed. 

Wheeler said leaving rates untouched wasn't an option because it risked letting already low inflation expectations bed in, which would drive headline inflation lower. If expectations sank too far, they would be difficult to lift back up. However, cutting rates more aggressively carried "considerable risks" and would use up the bank's capacity to respond to future shocks, putting it in the same boat as other central banks and running counter to the bank's mandate of avoiding unnecessary instability in the system. 

"We do not believe the outlook and balance of risks warrants a position of no policy change, nor a position of rapid easings," Wheeler said. "If the emerging information and risks unfold that warrants a change in our judgements, we will modify our policy settings and outlook." 

Nor did he agree with another set of critics who suggested the RBNZ should stop cutting interest rates.

"If financial markets believe that the Bank is content with below-target inflation, they would conclude that the easing process is over and proceed to bid the exchange rate up, perhaps substantially," he said.

The Reserve Bank has been contending with a high New Zealand dollar reducing import prices and pushing down the consumers price index - its mandated inflation gauge - while at the same time contending with a shortage of housing pushing up property prices. That tension has made Wheeler reluctant to cut interest rates too early for fear of inflaming the housing market, but meant New Zealand's interest rates are relatively higher than its peers and making the kiwi dollar more attractive. 

Wheeler said the kiwi dollar was still too high, and that if a "significantly higher exchange rate" wasn't matched by higher commodity prices it "would likely slow economic growth." Still, he said central banks generally have limited control over the exchange rate and "cannot persistently achieve a lower nominal exchange rate unless monetary policy is fully dedicated to that goal (and even then cannot permanently achieve a lower real exchange rate)."

The kiwi spiked up to 73.26 US cents from 72.68 cents immediately before the release and was recently trading at 72.84 cents. 

Wheeler said he expects as New Zealand's interest rate advantage narrows, the exchange rate will weaken, while an increase in commodity prices and gradual global inflation will help lift the country's tradable inflation into positive territory. 

He also defended the flexible inflation target framework saying it was the most appropriate policy for New Zealand as it allowed the central bank to take external shocks into account when setting the OCR. Like other central banks, the RBNZ has introduced macro-prudential tools to try and lean against inflated asset prices that have been stoked by near-zero interest rate policies and money printing programmes by the world's biggest monetary authorities, such as the US Federal Reserve and Bank of Japan. 

"Monetary policy in New Zealand remains effective and able to influence domestic demand, and thus, non-tradable inflation," Wheeler said. 

Central banks "have significant research and analytical capacity that can deliver valuable insights, and this is being applied to challenges associated with the current global economic and financial developments," Wheeler said. "It means that central banks are in a position to modify their perspectives and policies as new analysis and data becomes available." 

He rejected calls to lower the current 1-to-3 percent annual inflation target, saying that could damage the bank's credibility by making it easier to reach those goals when conditions get tougher. 

“There is nothing sacrosanct about what particular inflation band or target should be adopted as a measure of price stability. However, changing a target when times become tougher reduces the incentives on central banks to achieve earlier agreed goals. It could damage the central bank’s credibility – particularly if a perception develops that the central bank will continually seek to respecify goals.”

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