Reserve Bank governor Graeme Wheeler acknowledged calls to cut interest rates, given the tumbling price of crude oil, before arguing that keeping rates on hold was the most prudent option given the potential for domestic inflation to accelerate.
Wheeler set out the bank's thinking in a speech to the Canterbury Employers' Chamber of Commerce a week after he shifted monetary policy to neutral and said the next move in rates could be up or down. He said the biggest risks to the New Zealand economy, which is "performing well", are uncertainties over China's economy and four key prices - dairy, crude oil, houses and the exchange rate.
A supply side driven drop in the price of crude oil to around US$50 a barrel would deliver a $2.3 billion reduction in the cost of New Zealand's annual petroleum imports, amounting to 1 percent of nominal gross domestic product compared to mid-2014 levels. That amounts to a $600 annual increase to a household's disposable income, Wheeler said.
"Some commentators have suggested a cut in interest rates would be appropriate at this stage," Wheeler said. "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."
A rate cut could also be warranted if domestic demand and price pressures fell further, perhaps in response to drought or some external economic event, he said.
"However, in our current situation there are important considerations why a period of OCR stability is the most prudent," Wheeler said today. While falling commodity prices reduce headline inflation for a period they don't deliver sustained weaker inflation.
Headline inflation in New Zealand also doesn't reflect underlying cost pressure in the non-tradables sector, and the bank's medium term forecasts and measures of core inflation "are well within the target band," he said.
He noted New Zealand is the only advanced economy with a positive output gap the past two years, a falling jobless rate, strong migration, strong labour force participation and upbeat business and consumer sentiment. The country has also experienced an effective easing in credit conditions, with declines in fixed rate mortgages "at a time when we have financial stability concerns about accelerating house prices in Auckland."
Wheeler said the bank "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.
"We will be talking more about the housing market over the next few months," he said. While the bank's loan-to-value restrictions helped constrain demand, house price inflation "appears to be increasing again in Auckland due to rising household incomes, falling interest rates on fixed rate mortgages, strong migration inflows and continued market tightness."
Wheeler repeated that the New Zealand dollar "remains unjustified in terms of current economic conditions" and is "unsustainable in terms of New Zealand's long-term economic fundamentals."
The New Zealand dollar was recently at 73.70 US cents, from 73.35 cents immediately before the 1pm release of the speech.
