RBNZ rate cut might get inflation back up to target sooner, McDermott says

The Reserve Bank might be able to accelerate inflation to its target 2 percent sooner than expected if it cuts rates, but that would come at the expense of plumping an already bubbling property market, assistant governor John McDermott says.

The ‘Think Big’ projects of the 1970s are evidence that sustainable long-term growth can’t be achieved by “tolerating a bit more inflation,” and the most useful thing the central bank can do to support the economy “is to keep aggregate inflation predictably low, so that it can form a useful benchmark for pricing behaviour,” McDermott told Finsia members in Wellington.

With annual inflation running below its 1 percent to 3 percent target band at 0.9 percent, lifting it to the mid-point could be achieved faster with the official cash rate being cut from its record-low 2.5 percent.

“An interest rate cut might help inflation return to target sooner,” he said in speech notes published on the RBNZ’s website. “But such a cut would also probably exacerbate the current strength in house prices, risking further increases in private debt levels, potentially raising financial stability issues.”

That leaves the central bank facing trade-offs when reviewing monetary policy, with its current dilemma between encouraging currency speculators if it raises interest rates or boosting home buyers if it cuts, he said.

Governor Graeme Wheeler kept the benchmark rate on hold yesterday, while warning he could cut if the currency appreciates for no fundamental reason. Highlighting the tension the bank faces, he also told legislators an out of control property bubble was the last thing the country needs.

The Reserve Bank estimates house prices increased in real terms at an annual pace of 6 percent last year, and will rise 6.2 percent and 3.6 percent this year and the next.

McDermott said an interest rate hike might reduce housing market risks while putting the currency under “further upward pressure.”

The strength of the currency and the Canterbury rebuild are seen as the biggest question marks for the Reserve Bank’s forecasting team, which McDermott says has a better than average track record than other forecasters.

McDermott said the bank doesn’t expect rising construction costs in Canterbury to spillover into the wider economy, and household debt means consumer spending isn’t predicted to follow the upturn in the housing market.

“Since there is little recent experience against which to benchmark these events, we will have to monitor the evidence carefully to ensure that our judgements in this area remain reasonable,” he said.


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