Benign inflation, dairy price slump may spur more aggressive rate cuts

Thursday 16th July 2015

The Reserve Bank may have to cut interest rates more aggressively than previously signalled as it contends with an unexpectedly sharp slump in dairy prices and the prospect of low inflation becoming embedded in the economy.

Governor Graeme Wheeler will review the 3.25 percent official cash rate next week and is expected to cut it by a quarter point, having embarked on an easing cycle last month as inflation remains below his target band and as falling dairy prices lead to a deterioration in the country's terms of trade. Government figures today show the consumers price index rose 0.3 percent in the year ended June 30, though the non-tradable component, which covers domestic inflation, was at its lowest level since December 2001 at 2 percent.

The data pushed the New Zealand dollar to a new five year low 65.58 US cents, adding to concerns after the latest GlobalDairyTrade auction showed a 13 percent drop in whole milk powder prices and raised the prospect that Fonterra Cooperative Group will have to slash its forecast payout to farmers when its board next meets on Aug. 7.

"You've got to think this is going to cause significant belt tightening in the regions, so while the rest of the economy is doing okay, you've got a bigger downside risk," said Darren Gibbs, chief economist at Deutsche Bank New Zealand. "If you've got that sense of downside risk and inflation which is very benign, particularly non-tradables, there's nothing to stop the RBNZ from responding to that and lower the cash rate further."

Gibbs still expects Wheeler will cut the OCR by 25 basis points at each of the next three meetings, removing the 1 percentage point added last year, and said the question is whether the Reserve Bank decides to lower the rate more steeply at the September meeting when it next reviews its forecasts.

Traders are pricing in a 100 percent chance Wheeler will lower the key rate next week, and have priced in 61 basis points of cuts over the coming 12 months, according to the Overnight Index Swap curve.

Gibbs said the next key piece of information for the Reserve Bank will be employment data in August after the first quarter labour market surveys showed unemployment remained elevated while wage growth was very weak, and if that trend persists it will "embed this very weak domestic inflation, and that would be the nail on the head for the RBNZ to certainly take away all of last year's rate hikes."

BusinessDesk.co.nz

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