New Zealand primed for aggressive rate cuts as inflation and economy fade

[WELLINGTON] New Zealand's central bank looks set to be forced into more aggressive interest rate cuts to support a flagging economy beset by crumbling dairy prices, sliding sentiment and low inflation.

At least one analyst is predicting rates may drop by as much as 125 basis points to a record-low two per cent by year-end, highlighting the rapid downturn in fortunes for the agricultural-based economy which only last year was being touted as a "rock-star" among developed nations. "We were already expecting a 25 basis point cut next week and stick to that call, although a straight 50 bps cut is now a real possibility," said HSBC chief economist Paul Bloxham.

Bloxham's shifting view mirrored growing headwinds for the US$160 billion economy. Data on Thursday showed inflation rising just 0.3 per cent in the year to June 30, while the latest dairy auction saw prices slump to a six-year low, and consumer sentiment dipped to its lowest in three years.

A month ago the Reserve Bank of New Zealand (RBNZ) cut its cash rate by 25 basis points as it started to unwind last year's 100 basis points (bps) of tightening, which took the rate to a five year-high of 3.5 per cent.

But what was seen as likely to be a gradual and cautious easing now looks like turning into a rapid retreat, reflecting an economy set for annual growth closer to 2.0 per cent from the plus-3.0 per cent rates of the past two years.

A Reuters poll has a rate cut on July 23 as a certainty, with a consensus view the RBNZ will cut its cash rate and settle at 2.50 per cent by the first quarter of next year.

The New Zealand dollar slumped 1.1 per cent to a six year low of US$0.6505.

The RBNZ is under pressure to lift inflation towards 2 per cent, the middle of its target band, but the latest data showed surprising weak underlying price pressures.

The quarterly CPI rise was mainly driven by an 8.8 per cent hike in petrol prices.

The RBNZ looks through short-term price volatility, but remains alert for domestic price pressures - such as housing and building costs - which rose 0.1 per cent for the quarter and by 2.0 per cent for the year, the lowest since 2001. "Today's inflation figures highlight that the Reserve Bank has its work cut out for it, as it aims to bring inflation back towards the 2 per cent midpoint of its target over the next couple of years," said Westpac senior economist Michael Gordon.

Gordon is now picking much more aggressive easing of a further 100 basis points - on top of next week's 25 bps cut - by the end of the year taking the cash rate to 2 per cent.

Arguments against such radical rate cutting include stoking an already overheated housing market, and the more than 5 per cent slide in the New Zealand dollar over the past month, which will raise the cost of imported goods.

But HSBC's Bloxham said the central bank has bigger issues. "For the RBNZ, upside risks have now been taken off the table. We believe action is needed to support the dairy sector in the short term and, in the medium term, to ensure that inflation stabilises close to 2 per cent."

REUTERS