RBNZ signals that it intends to move cautiously on interest rates

This morning Reserve Bank Governor Graeme Wheeler delivered a speech titled "Some Thoughts on the Inflation Outlook and Monetary Policy". The speech largely reinforced the message of last week's OCR review statement, which revealed a very cautious approach to the recent softening in New Zealand's economic conditions. The RBNZ is prepared to cut the OCR again in September but seems to be on the fence about a further cut this year, which is more or less where market pricing currently stands.

The RBNZ remains reasonably positive on the domestic economy (pending a full review of its forecasts at the September Monetary Policy Statement). The plunge in world dairy prices is clearly a concern, and the OCR cuts to date were aimed at providing a buffer against this shock. But overall, the RBNZ sees growth running just "a little below trend", supported by easier financial conditions, high net migration, growth in construction and strength in the services sector.

Notably, the Governor had a pointed message for the market: "Some local commentators have predicted large declines in interest rates over coming months that could only be consistent with the economy moving into recession." This suggests two things: that the RBNZ is not inclined to move in increments of more than 25bps and that it doesn't currently expect to reduce the OCR much below its current level.

Financial markets were anticipating a less 'dovish' tone from today's speech in light of last week's OCR review, but seem to have been further surprised by the Governor's comments. The NZD trade-weighted index rose 0.5% after the speech, and is up more than 2% since the OCR review.

"We remain comfortable calling for a low point in the OCR of 2.00%. This view is not based on a forecast of recession, but on what will be needed to meet the RBNZ's inflation target over the medium term. We expect that the flow of information over the next few months will persuade the RBNZ to lower its interest rate projections further," says Westpac Research.

Annual inflation is currently just 0.3%, and it has been consistently below the 2% midpoint of the target range for almost four years. The RBNZ expects inflation to be close to the 2% midpoint by the first half of 2016 (a mild downgrade from the "early 2016" in last week's OCR statement), with the recent fall in the NZ dollar pushing up the prices of tradable goods. The RBNZ judges that this is an appropriate pace of adjustment back to its medium-term inflation target.

However, a fall in the exchange rate will only generate a transitory burst of inflation (with a lag of up to a year). Meanwhile, non-tradables inflation is already weak, and the softer growth outlook and the peak in the construction boom suggest any material pickup is some way off. So maintaining inflation close to 2% is likely to require sustained tradable goods inflation - which in turn requires a sustained decline in the NZ dollar - or a significant pickup in domestic activity. But neither of those will happen if the RBNZ cuts the OCR by only another quarter percent or so.