Why Adrian Orr will face pressure to cut

The Reserve Bank is stuck in a holding pattern ahead of the arrival of a new boss. But as the Government hopes to push unemployment well under four percent pressure is growing for it to cut interest rates.

The old guard still running the Reserve Bank is in no mood to cut interest rates, but new Governor Adrian Orr will face pressure from the Government and some economists to cut when he arrives in just over six weeks as inflation remains stubbornly at the bottom of the bank's target band.

A difference of opinions and economic models is also brewing between the Government, which wants to see the Reserve Bank maximise employment and help push unemployment well below four cent, and the Reserve Bank's current economists, who see the economy already running at full capacity with full employment around 4.7 percent.

The problem for the Reserve Bank is unemployment is already at 4.5 percent and yet wage inflation remains modest. This calls into question its view the economy is already revving past its speed limit of 4.7 percent. Wage inflation was below 2.0 percent in the December quarter and the Reserve Bank's preferred measure of core inflation was just 1.4 percent.

However, the bank's retiring Acting Governor, Grant Spencer, was implacable on Thursday, saying the bank should be patient with its wait for inflation to come. He said stability was more important than taking a risk to run the economy faster, given the risk of a reappearance of inflation. The Reserve Bank's preferred measure of core inflation has been below the two percent midpoint of the bank's 1-3 percent target band for eight years and inflation was surprisingly weak again in the December quarter.

This chart shows how the RBNZ has consistently over estimated inflation and interest rates in the last six years.
This chart shows where the Reserve Bank forecast interest rates and where they ended up over the last five years. The bank has consistently over-estimated future inflation.

But the Reserve Bank forecast again on Thursday that it saw inflation eventually getting back up to 2.0 percent by the end of 2020. It left its Official Cash Rate on hold at 1.75 percent and forecast it would not need to increase the rate until late 2019. It saw just two rate hikes to 2.25 percent by early 2021.

"Given the growth story and the capacity story there is going to be the question of when inflation is going to come back," Spencer told Parliament's Finance and Expenditure Select Committee Chair Michael Wood when asked if there was room for more cuts.

"We don't think it's a good thing to have policies that chop and change. We have a steady hand on the tiller, rather than having to negotiate each wave," he said.

"When you look at the international scene and the sort of thing that you had last week which showed that people are getting nervous about a pickup in inflation globally...if that happens then that would make us revise upwards our projections for inflation and potentially interest rates, so that wouldn't look too good if we were easing rates and having to move back in the other direction in a short space of time," said Spencer.

Spencer went on to detail the other key concern in the bank's decision-making: the housing market, which had begun to slow.

"Any reduction in the interest rates could risk reigniting the housing market, causing debt-to-income ratios to increase. Household debt is very high at 168% of the average household income and we're just getting to a point where it's starting to come off," he said.

"The risk is that if we reduce interest rates more people will go out and get mortgages and that debt ratio might start to increase again."

The question for Orr, currently the CEO of the NZ Super Fund, and the Government is whether they trust the Reserve Bank's forecasts, which have consistently over-estimated inflationary pressures and under-estimated the capacity of the economy over the past five years, or whether they revisit the bank's models and take a different view of where the economy's speed limit lies.

Finance Minister Grant Robertson has said he wants to see unemployment driven significantly below four percent and has pointed to the 3.3 percent low it reached in late 2007 when Labour was last in power.

He has also launched a review of the Reserve Bank's targets to widen them to include maximising employment alongside targeting 1-3 percent inflation. The question of where exactly full employment lies is a crucial one in this debate, especially when some argue globalisation, the casualisation of work, new technology and de-unionisation has structurally changed the usual relationship driving inflation up as unemployment falls. Such a change would effectively have increased the speed limit and allowed the Reserve Bank to cut interest rates more.

The first opportunity to see how Robertson and Orr view the task ahead will be when they sign a refreshed Policy Targets Agreement under the current Reserve Bank Act within coming weeks.

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