The monetary policy easing cycle in New Zealand is now well underway with the cash rate which influences bank mortgage rates so far cut from 5.5% to 4.25%.

The chances are high that by the middle of next year the rate will be at 3.5% and this will flow through to lower returns mainly on short-dated bank term deposits and fixed mortgage rates out to about two years.

Beyond that the scope for rate declines for both borrowers and investors is not looking all that strong.

This outlook for only muted further interest rate declines especially for medium to long periods may seem unusual when considering my view since August that the speed of recovery in our economy will be quite mild – perhaps disappointing in fact.

Falling interest rates will help lift activity and we can already see sharp gains in business sentiment alongside their investing and hiring intentions. Household spending is also showing signs of stabilising after three years of decline and there is clearly a boost to economic activity around the country to come from higher infrastructure spending, better dairy prices, still positive net migration inflows, and slowly rising house prices.

But over one-quarter of our export receipts come from China and the outlook for growth in the world’s second largest economy is not good as families curb spending to rebuild wealth lost in property investments. Construction is weak and the central government is reluctant to engage in another bout of debt-funded infrastructure stimulus.

China is also the economy most vulnerable to higher tariffs promised by the incoming US President. Those higher tariffs bring a risk of retaliation by other countries which will tend to boost global inflation while retarding economic growth rates.

But there are two key factors which suggest that even though New Zealand’s upturn will be mild, there is a strong risk the cyclical recovery in inflation appears quite early.

First, as highlighted by both Treasury and the Reserve Bank recently, New Zealand’s rate of productivity growth
seems to have permanently slowed. This means that inflation tends to appear at lower growth rates than would otherwise be the case. It is worth noting for instance that in adjusting for a worse prediction of future productivity growth the Reserve Bank have just cut its growth forecasts for each of the next two years by about 0.6% yet lifted their inflation predictions slightly.

The second factor is a product of the way business margins are currently being squeezed to the greatest extent since 1976 according to a measure I track. When we look at what businesses expect for only the next three months a below average proportion say they will raise their selling prices. That is great for inflation and explains why interest rates are being cut by the Reserve Bank. But an above average proportion say they still expect their costs to go up. At the moment businesses cannot get away with margin-protecting price rises because customers won’t stand for it. But a separate survey by the ANZ which looks ahead not three months but 12 shows that a well above average proportion of businesses plan to raise their prices.

That is, once the better economy they expect brings greater customer numbers through the doors they intend rebuilding their currently crunched margins by raising prices.

The upshot is that the cash rate set by the Reserve Bank will most probably be cut another 0.5% come February 19 and 0.25% on April 9. The rate then will sit at 3.5%. The risk is that this is as low as it goes this cycle. Having said that, none of us really know what is going to happen in
world oil markets as the situation changes in the Middle East, and with global trade, inflation, and growth once January 20 brings the return of Mr Trump.

This article has been provided for general information only. Tony Alexander is an independent economist and produces a free weekly publication with a housing focus called "Tony's View". You can sign up at www.tonyalexander.nz