How low could interest rates go, as employment and inflation weaken?

Wednesday, 8 May 2019

In March, Reserve Bank governor Adrian Orr caused surprise when he indicated the next move for interest rates could be down. Since then employment figures have been disappointing, leading to considerable speculation that the Reserve Bank will cut the official cash rate to an all time low today.

OPINION: When Statistics New Zealand released employment data on May 1, it appeared to show the labour market remains in rude health.

The unemployment rate dropped marginally to 4.2 per cent, close to the lowest level New Zealand has seen in a decade, and below where it was at the time of the 2017 election.

Employment Minister Willie Jackson celebrated the news, describing it as evidence of Government 'policies that support workers and business'.

But underneath the unemployment rate - which always attracts a disproportionate amount of attention when the quarterly household labour force survey is released - was news that the number of people who have jobs is actually falling.

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According to Statistics New Zealand, at the end of March, there were fewer people employed in New Zealand than at the end of September 2018.

The unemployment rate only fell in the recent quarter because even more people had indicated they were no longer looking for work and are therefore not considered part of the labour force.

This in spite of a growing population, boosted by gains from migration.

Aside from rising petrol prices, inflation appears set to come in below expectations.

'It appears some (potential) workers have been discouraged and given up the search for work,' economists at Kiwibank said of the figures.

While the drop in jobs has been only marginal, it is a further sign that the economy is stalling. Business confidence remains low and economic growth remains positive, but is slowing.

Aside from resurgent petrol prices, inflation appears set to come in below expectations and below where the Reserve Bank's ideal target.

On Wednesday afternoon, governor Adrian Orr will walk into the Reserve Bank's museum to explain to reporters either why the central bank has cut interest rates to an all time low, or he will hint again that the official cash rate (OCR) will be cut to all time lows some time in the near future.

Even this level of uncertainty is unusual.

Typically, economists are virtually unanimous on what the outcome of an OCR decision will be days before it is made and are instead focused on comments which offer a clue as to what will happen next time.

In the words of Westpac chief economist Dominick Stephens, this week's decision is 'on a knife edge'.

Economists are generally split between those who say the news has been weak enough to justify an immediate cut, and those who say it is worth waiting.

The uncertainty appears to be based on the fact that the way the decision will be made is quite different to how it has been done in the past.

For the first time since the OCR was introduced in 1999, it will not be the governor who ultimately makes the decision.

Instead, three figures from outside the Reserve Bank's staff will sit on a panel of seven who will make the decision.

Coupled with this, a number of senior officials have recently left the bank, meaning fresh perspectives will be at the table.

The Reserve Bank's former head of economics Dr John McDermott was known to focus on employment growth (and was, at times, downright dismissive of the accuracy of the unemployment rate). He would almost certainly be lobbying for a cut this week.

But less is known about the focus of his replacement, Christian Hawkesby, a former Bank of England official who in recent years has worked in fund management.

Interestingly, as his official profile attests, Hawkesby's time in London gave him experience when the Bank of England embarked on quantitative easing.

This is economist-speak for 'printing money', when people are quite literally paid to borrow.

This experience may come in handy, because the question appears to be firmly a question of when, not if, interest rates will be cut.

Orr said as much back in March, the last time the OCR was reviewed.

Although at the time he made the statement the market expressed surprise that Orr's position appeared to have moved so significantly, in the weeks since the New Zealand economy has showed signs of weakness which would appear to validate the shift in stance.

BNZ has warned a cut now could be a mistake; not only are businesses more concerned about policy uncertainty than they are about interest rates, economists warn cutting now will mean the bank could have less firepower left when it really needs it.

The problem is, Orr has indicated which direction he sees interest rates going. He has a dual mandate to target inflation and maximum sustainable employment.

On both measures, the economy is weakening. Having signalled to financial markets that the bank is leaning towards cutting interest rates, there could be a sharp jump in the New Zealand dollar if traders start to doubt the governor will follow through.

Even though the economy may hardly be in a sick state, the OCR may soon head to fresh record lows.

If conditions were to then to really deteriorate, possibly driven by international factors which are completely outside our control, then it will become a question of how low can they go?