Inflation rebound unlikely, OCR heading for 2%, says Westpac

Inflation is likely to undershoot the Reserve Bank's forecast in 2016 because of an unexpectedly strong kiwi dollar, adding to the case for deeper interest rate cuts, Westpac Banking Corp economists say.

The trade-weighted index was recently at 72.92, more than 7% above the average 67.9% level the central bank projected for the fourth quarter in its September monetary policy statement. While the TWI sank as low as 68.18 in late September, it has since rebounded to a five-month high, instead of following the central bank's forecast track for a decline running through late 2016.

Governor Graeme Wheeler cut the official cash rate to 2.75% in September while flagging a further 25 basis point cut, which may come as soon as the December 10 Monetary Policy Statement. Westpac chief economist Dominic Stephens says Mr Wheeler will have to cut the OCR to 2% to achieve a rebound in inflation next year.

"Boosting inflation from today's low rate to 2% on a sustained basis will be a daunting task for the Reserve Bank," Mr Stephens said. "The Reserve Bank is firmly of the view that the OCR will have to fall to 2.5% but no further. We are doubtful that will be sufficient. In our view, the OCR will eventually have to fall to 2%.

Westpac is forecasting annual inflation to rise to 1.2% in the 12 months ending September 30, 2016, from 0.4% in the September 2015 year. That's well below the Reserve Bank's forecast of 2.1%. Westpac doesn't expect inflation to return to the mid-point of the central bank's 1-3% target range until September 2017.

Mr Stephens said the Reserve Bank got it wrong in September when it argued a lower exchange rate would provide a "substantial and sustained" boost to inflation by boosting the cost of imported goods, and therefore tradables inflation. Uncertainty about the timing of a rate hike by the US Federal Reserve, a lift in dairy prices and a relatively sturdy domestic economy have helped underpin the kiwi dollar, while concerns have abated that China, New Zealand's biggest trading partner, is heading for a sharp slowdown.

Westpac senior economist Michael Gordon told BusinessDesk that the Reserve Bank had predicted a pickup in tradables inflation, which was beyond what the bank had seen, and he had been skeptical for some time about the predictions.

Westpac expects the central bank will have to cut the OCR in December 2015, March 2016 and June 2016 as data shows inflation is lagging behind its expectations.

The Reserve Bank will have no choice, Mr Gordon said. "We have to assume they will do what's needed. If they are serious about getting back to the 2% midpoint of their target, they will have to cut the OCR further."

(BusinessDesk)