Inflation key for interest rates

An ongoing decline in inflation expectations could mean interest rates drop further, but some are nervous about the trade-offs involved.

Monday, March 14th 2016, 2:16PM

by Miriam Bell

Inflation expectations have been a surprisingly hot topic lately – with much speculation about how long inflation will stay low and what it might mean.

HSBC has even released a paper on the challenge persistently low inflation presents for the Reserve Bank’s 25-year old inflation targeting regime.

Following the surprise cut to the OCR last week, it was noted that the Reserve Bank was obviously more focused on headline CPI and inflation expectations than it had previously indicated.

And now the Reserve Bank has said recent trends in inflation expectations have important implications for current monetary policy.

In conjunction with today’s release of an article on the topic, Assistant Governor John McDermott said there has been a decline in inflation expectations recently.

This decline risks becoming embedded in future wage and price decisions and is contributing to the current need for low interest rate settings, he said.

“Low interest rate settings will help offset the dampening impact low inflation expectations will have on today’s wage and price setting behaviour.

“They will also help ensure inflation expectations remain well anchored.”

McDermott said that, if the recent decline in a broad range of inflation expectations measures continues, the Reserve Bank would need to reconsider the outlook for interest rates.

Massey University banking expert David Tripe said this could mean the Reserve Bank would cut further if inflation expectations continued to decline.

Conversely, it could mean the potential for a change of tack from the Reserve Bank, he said.

“Both are realistic possibilities. But my guess would be they are more likely to make further cuts under those circumstances.”

ANZ chief economist Cameron Bagrie was nervous about this prospect.

He said that, while ANZ could rationalise further cuts on broader inflation grounds, they were becoming somewhat uneasy about the trade-offs.

“Surging debt and asset price inflation foretell problems down the track; there is no free lunch.”

He said ANZ are not big believers in a rigid approach to inflation targeting, and didn’t think the RBNZ was either.

“But the cut last week suggests it is certainly less flexible and relaxed than we assumed after the Governor’s February speech.”

Meanwhile, the latest NZIER Consensus Forecasts showed economists have dropped their inflation expectations.

The timing for when headline inflation will get back within its 1-3% inflation target bank has been pushed back by around a year, according to the forecasts.

However, the consensus is still for headline inflation to edge close to the 2% midpoint target from the second half of 2017.

Tags: interest rates OCR RBNZ