6 Jun 2024

Reserve Bank approach 'a recipe to prolong the pain'

3:00 pm on 6 June 2024
Reserve Bank governor Adrian Orr.

Infometrics' chief forecaster fears that Reserve Bank Governor Adrian Orr could "keep monetary policy tighter for longer than is necessary in terms of broader economic and inflationary outcomes". Photo: RNZ / Dom Thomas

Households may have to suffer more interest rate pain than necessary because the Reserve Bank is too "backward looking" in its approach to the official cash rate (OCR), according to one leading forecaster.

Infometrics chief forecaster Gareth Kiernan has updated his prediction for when the OCR will move, and now expects a cut in February next year rather than this November.

He said, while he did not think it was necessarily the right move, the central bank's "backward looking" approach to monetary policy meant an OCR reduction was probably further away.

"Back in the second half of 2021, the bank doggedly clung to its belief that the surge in cost pressures was temporary, meaning that it was too slow and gradual to lift interest rates.

"Throughout 2022 and early 2023, the bank repeatedly highlighted issues in its monetary policy decisions that other analysts had been discussing months earlier, giving the impression that it was always behind the play and reacting to old data.

"We see nothing in the bank's recent behaviour to suggest that it is doing any better at setting monetary policy with a forward-looking perspective."

Kiernan said, based on current Reserve Bank forecasts, by the final quarter of this year, it could look to consumer price inflation of 2 percent in the first half of 2026, as well as non-tradeable inflation of 2.7 percent and labour cost growth of 2.5 percent.

"We think there is enough of a moderation to enable the bank to start gradually easing monetary conditions - particularly in the context of deteriorating economic outcomes since the start of 2024.

"To put it another way: if the bank doesn't cut the OCR until the September 2025 quarter, it will only be starting to ease when headline inflation has already slowed to 2.2 percent, yet monetary conditions will still be heavily restrictive. That approach is a recipe to prolong the pain that households and businesses are currently feeling beyond next year and out as far as 2027."

Westpac chief economist Kelly Eckhold said he did not agree that the bank was too backward-looking. "Their problem is they've been surprised to the upside in domestic inflation. They're telling us they need to see improvement on that score."

Non-tradeable inflation has been a major headache for the Reserve Bank - that is inflation that is domestic and not influenced by international factors.

It makes up about 60 percent of the consumer price index (CPI), which the Reserve Bank is trying to pull down to an annual rate of increase of 2 percent, from twice that currently. But it has hardly moved over a year.

Kiernan said much of that inflation was due to factors that the bank had little or no control over, such as rates, insurance and electricity.

As they continued to increase at a double-digit percentage pace in some cases, the Reserve Bank would have to target even lower price rises across other items to get inflation to 2 percent, he said.

"Reserve Bank Governor Adrian Orr said during the latest Monetary Policy Statement press conference that 'eventually monetary policy will win the day, but they [insurance and rates and rents] are just less sensitive.' If the Reserve Bank Governor thinks monetary policy has any effect on rates, insurance, or electricity prices, he is set to be disappointed. His response to this disappointment might be to dogmatically keep monetary policy tighter for longer than is necessary in terms of broader economic and inflationary outcomes."

ANZ economists agreed it was a problem. They said price changes that were structural in origin were a particular challenge. There was an element of structural change in insurance, where weather risk was pushing up prices, and council infrastructure challenges.

But they said it was likely to be the case that the "baked in persistence" of these factors was a reason why monetary policy was taking longer to have an impact than in previous cycles. "That's preferable to the alternative explanation: that monetary policy isn't working… The Reserve Bank has to weigh up the risk of holding policy too tight for too long against the risk that disinflation peters out before the job is done," Kiernan said.

ASB economists said they expected the Reserve Bank to keep the cash rate on hold until February but a cut could come later.

BNZ also expects a February cut. "We pushed that out from November following the recent Reserve Bank meeting. A November move is still possible, but the balance of probabilities now favours a 2025 start to the easing cycle," chief economist Mike Jones said.

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