Tomorrow will see the Reserve Bank make a decision on whether to change the official cash rate from its current level of 8.25%.
Although some commentators believe that the slowing pace of domestic economic activity merits a rate cut, most economists agree that leaving rates unchanged at the moment would be prudent. Here’s why:
1) We do have an inflation problem:
Although the media is keen to blame current inflation solely on the pick up in food and oil prices (which can just be viewed as a change in relative prices) there is a significant amount of actual inflation (broad based increases in the price of all products) in the New Zealand economy. This is a consequence of the economy running close to full capacity for so long – the expectation of rising prices has, to some degree, become entrenched in peoples planning decisions. Given the long-term costs associated with inflation we have mandated to Bank to focus on it – and so it shall when it looks at the OCR.
2) The slowdown is the result of supply shocks – not underconsumption/excess savings.
There seems to be a school of thought that lower interest rates will stock demand and save our economy from a recession. Conversely we have a situation where people are demanding that people save more (Kiwisaver etc), but we are also demanding that people consume more. As income is limited this isn’t likely to happen.
The slowdown in economic activity is the result of several negative economic “supply” shocks in recent months, namely higher food and oil prices and drought. Now any belief that lower interest rates (which in the short run will stoke demand) will help us in this situation is mis-leading.
When we suffer negative supply shocks the economy has to move into a lower output-higher price stage. Where the interest rate is set determines the trade-off between these two. In the absence of any future positive or negative supply shocks (eg, technology) this would imply that the economy can only produce less – no amount of fiddling with the “short-term” interest rate will change this.
Furthermore, any cut to interest rates could lead to a further negative supply shock – just when we don’t need it. If the value of our exports is relatively unresponsive to changes in the exchange rate (say through contract prices denominated in $NZ) then the main impact of a lower exchange rate from lower interest rates will be an increase in import prices – a further supply shock.
A rate cut tomorrow won’t just tell the market that the OCR is now 8.00% – it will give the market the impression there is more to come. Changes in the official cash rate tend to be persistent, and as a result the market will expect this to be the beginning of a tightening cycle. Even if it would be prudent to have the OCR at 8% doing so now would entail a much larger reaction from the market – namely longer term interest rates and the exchange rate.
Don’t cut rates tomorrow – don’t cut rates this year. If we do we will have to sacrifice more growth in the future.