Reserve Bank Governor Graeme Wheeler delivered this message in a speech to the Canterbury Employers Chamber of Commerce in Christchurch today.
Mr Wheeler said that the Bank expects above-average economic growth in New Zealand’s trading partners this year. However, there are more risks and uncertainties as growth rates diverge between countries, central banks continue significant quantitative easing, and consumer price inflation falls into negative territory in several countries.
At the same time, financial markets have had to respond to several developments, including the Swiss National Bank abandoning its exchange rate cap, interest rate cuts by several central banks, and uncertainty following the Greek election.
“Nevertheless, in most respects, the New Zealand economy is performing well,” he said. “The main risks and uncertainties relate to the Chinese economy, and four key prices – dairy prices, oil prices, house prices and the exchange rate.”
An expected NZD 6 billion drop in dairy farmers’ incomes is likely to be cushioned as farmers normally smooth spending through swings in income. Many farmers also used last year’s record pay-out to bolster farm balance sheets. But if prices do not recover as expected, spending could slow more sharply in 2016, Mr Wheeler said. A further risk to farm incomes stems from dry weather in several of New Zealand’s dairy regions.
Oil prices have fallen 58 percent since the end of June 2014. If they remain around USD 50 per barrel, this would boost household disposable income by around $600pa per household. However, if the main driver of the fall in oil prices is weakening global demand, New Zealand’s export incomes can expect to continue to be weak.
The Bank will monitor the impact of lower fuel prices on downstream prices in the economy, and how much they might reduce households’ expectations of future inflation.
Mr Wheeler said the Bank’s concern about house price inflation is based on the risk it poses to financial stability and the broader economy. Its focus is mainly on the Auckland and Christchurch markets, where the housing shortages are greatest and where market pressures are the most intense. House price inflation appears to be increasing again in Auckland.
“Resolving the housing shortages is key. In Christchurch, this issue is expected to be resolved, although with longer delays. But in Auckland, much more needs to be done, especially in creating opportunities for residential construction in Auckland.
“We will continue to monitor housing developments carefully, and the role that the banking system may be playing in contributing to pricing pressures in the housing market.”
Mr Wheeler said that, while the New Zealand dollar has eased recently on a TWI basis, it remains unjustified in terms of current economic conditions, particularly export prices, and unsustainable in terms of long-term economic fundamentals. “We expect to see a further significant depreciation.”
He said that annual CPI inflation is expected to be below the Bank’s target band and could become negative for a period during 2015, as the direct and indirect impacts of falling oil prices feed through the economy. The Bank then expects inflation to move back towards the middle of the 1 to 3 percent target band, albeit more gradually than previously anticipated.
In the current circumstances, the Bank expects to keep the OCR on hold for some time, and that future interest rate adjustments, either up or down, will depend on the emerging flow of economic data.
“Some commentators have suggested that a cut in interest rates would be appropriate at this stage. With a sizeable positive supply side shock, such as a major fall in the price of oil, a cut in interest rates can be appropriate if there is sufficient capacity to accommodate additional demand. Monetary policy settings could also warrant easing if domestic demand deteriorated and domestic price pressures abated further, perhaps in response to drought or a worsening in external economic circumstances.
“However, in our current situation there are important considerations why a period of OCR stability is the most prudent option.
“Commodity price declines reduce headline inflation for a period, but do not deliver a sustained decline in inflation. Weak or negative headline inflation is not reflective of underlying cost pressure in the non-tradables sector of the economy, and our medium-term forecasts and measures of core inflation are well within the target band.
“New Zealand is the only country among the advanced economies that has had a positive output gap in the past two years, our unemployment rate is low and falling, net inward migration and labour force participation is at record levels, and business and consumer confidence surveys remain strong. In addition, we have already seen some effective easing of credit conditions with declines in fixed-rate mortgages, at a time when we have financial stability concerns about accelerating house prices in Auckland.
“Similarly, before any decision to raise interest rates, we would need to be confident that capacity utilisation and labour market pressures were generating, or about to generate, a substantial increase in inflation.”
Mr Wheeler concluded that the drivers of growth look sustainable, particularly in light of the increase in productive capacity that has occurred in recent years. Monetary policy remains in a strong position to continue supporting ongoing low inflationary growth in the New Zealand economy.
Read the speech: The outlook for the New Zealand economy