In the wake of the Reserve Bank’s May Monetary Policy Statement, Infometrics has pushed back our expected timing of the first official cash rate (OCR) cut from November 2024 to February 2025. Although we don’t think a further delay in beginning to cut the OCR is necessarily the right move, the Bank’s backward-looking approach to setting monetary policy means that households and businesses will need to wait longer for any interest rate relief.

Before we talk about cuts, though, let’s address the elephant in the room: OCR increases. In May, the Reserve Bank’s Monetary Policy Committee “discussed the possibility of increasing the OCR at this meeting.” This discussion coincided with a lift in the Bank’s forecast of the peak OCR from 5.60% to 5.65%. Although this shift looks relatively minor, Chart 1 shows that it was a reversal of the moderation in the previous forecasts and, at least symbolically, implies that another interest rate increase is more likely than not.

The Reserve Bank has subsequently stated that its OCR projections are “mechanistic”, describing the changes to the risks in its outlook as “slight” and not “a huge shift.” On its own, the significance of the change to the Bank’s OCR track could have been downplayed by financial markets. But coming in tandem with the explicit consideration of an interest rate rise at the latest meeting (and no similar wording in recent times), markets saw the Bank swinging back towards a much more hawkish view of the monetary policy outlook again.

In our view, there is no justification for another interest rate hike. One of the clear themes since February this year has been the deterioration in demand conditions, reflected in weaker business and consumer confidence, across virtually every part of the economy. Higher mortgage rates are biting harder than they did during 2023, with job losses and the weakening labour market becoming a more pronounced driver of activity as well. People will continue to roll off lower fixed mortgage rates throughout the rest of this year, and an unemployment rate pushing over 5% will create a new layer of worry around households’ financial security – negatively affecting spending and demand. In essence, the lagged effects of the OCR increases through until mid-2023 are only now being fully felt.

However, we are not convinced that the Reserve Bank will view economic conditions the same way as us. We currently estimate a 10% probability of the Bank increasing the OCR again before the end of this year – unlikely, but not entirely out of the question. The Bank’s reasoning would be influenced by the same factors covered in the following section, which explain why any OCR cuts are being further delayed.

What issues are concerning the Reserve Bank, and making it reluctant to consider cutting interest rates any time soon?

Non-tradable inflation has barely budged over the last year, easing from 6.8% to 5.8%pa. Chart 2 shows that the moderation in headline inflation, from 6.7% to 4.0%pa over the same period, has been mostly driven by moderating global price pressures, and that domestic (non-tradable) pressures remain elevated.

Non-tradable prices make up about 60% of the consumers price index (CPI), and these price pressures are the ones that should be most affected by the Reserve Bank’s monetary policy settings. The lack of slowdown in non-tradable inflation to date means the Bank is worried that the previous tightening has not had enough of an effect in bringing domestic price-setting behaviour under control.

Even within the non-tradable inflation subset, there are some prices that the Bank has little or no control over. Adding to the Bank’s struggles to get non-tradable inflation down further are some examples of large non-competitive price increases coming through the system, including for local authority rates, house insurance, and electricity. With double-digit increases coming through for all these items, the Reserve Bank will effectively have to target even lower price rises across the remainder of the CPI to get inflation back to its 2%pa target.

Strangely, Reserve Bank Governor Adrian Orr said during the latest Monetary Policy Statement press conference that “eventually monetary policy will win the day, but they [insurance and rates and rents] are just less sensitive.” If the Reserve Bank Governor thinks monetary policy has any effect on rates, insurance, or electricity prices, he is set to be disappointed. His response to this disappointment might be to dogmatically keep monetary policy tighter for longer than is necessary in terms of broader economic and inflationary outcomes.

One of the other areas that has attracted both the Reserve Bank and Treasury’s attention is weak productivity growth (see Chart 3). Treasury recently published a paper exploring the possible reasons behind New Zealand’s poor productivity performance, while the Reserve Bank noted that slower productivity growth implies weaker potential growth for the economy as well as less room for wage increases.

At its most simple, nominal wage growth can be thought of as a combination of inflation and productivity improvements. If productivity is not growing as strongly as previously, then the same nominal wage growth implies a higher inflation component instead. This relationship is particularly important at the moment given that wage inflation is still elevated compared to the norms of the last 20-30 years. In essence, the Reserve Bank is concerned that people will continue to demand bigger pay rises to make up for cost-of-living increases. However, without commensurate productivity improvements, these increased wages will simply feed through into higher cost structures for businesses, prolonging the period that domestic inflation remains uncomfortably high.

The government’s latest budget could also cause the Reserve Bank some concern. Although Finance Minister Nicola Willis strenuously argued that the government has not borrowed to fund its tax cuts, the weaker outlook for economic growth and tax revenue means that the government deficit is $7.3b larger than assumed in last December’s Half Year Economic and Fiscal Update. In this regard, the effect of fiscal policy on the economy is less contractionary than had previously been assumed, as shown by the estimated fiscal impulse in Chart 4, adding to aggregate demand and risking keeping price pressures elevated for longer.

The experience of the last three years has reiterated the fact that interest rate changes by the Reserve Bank take several quarters to flow through and affect real economic activity. In fact, given that as much as 90% of mortgage lending is on fixed rates, the average lags are probably longer than they have been historically, pushing out to as long as 18 months.

Unfortunately, the experience of the last three years has also suggested that the Reserve Bank has become less forward-looking in its monetary policy setting. Back in the second half of 2021, the Bank doggedly clung to its belief that the surge in cost pressures was temporary, meaning that it was too slow and gradual to lift interest rates. Throughout 2022 and early 2023, the Bank repeatedly highlighted issues in its monetary policy decisions that other analysts had been discussing months earlier, giving the impression that it was always behind the play and reacting to old data.

We see nothing in the Bank’s recent behaviour to suggest that it is doing any better at setting monetary policy with a forward-looking perspective. If the Bank’s latest forecasts are correct, then by the final quarter of this year, it could look forward to the first half of 2026 and see consumer price inflation of 2.0%pa, non-tradable inflation of 2.7%pa, and labour cost growth of 2.5%pa. Acknowledging that those figures are premised on the Bank’s current OCR track, we think there is enough of a moderation to enable the Bank to start gradually easing monetary conditions – particularly in the context of deteriorating economic outcomes since the start of 2024.

To put it another way: if the Bank doesn’t cut the OCR until the September 2025 quarter, it will only be starting to ease when headline inflation has already slowed to 2.2%pa, yet monetary conditions will still be heavily restrictive. That approach is a recipe to prolong the pain that households and businesses are currently feeling beyond next year and out as far as 2027. Such a long downturn for the economy would almost certainly drive inflation down towards the bottom of the Bank’s 1-3%pa target band. Just as the Bank’s slow reactions contributed to strong cost and inflation pressures on the way up, its delayed response could also see inflation undershooting on the way down. So much for the Bank’s requirement to “avoid unnecessary instability in output”, as specified in its Remit.

For now, we’ve pushed our expected timing of the Reserve Bank’s first interest rate cut to February next year, when the Bank should have data showing headline inflation below 3%pa and non-tradable inflation below 4%pa. We hope that the additional six-month wait in the Bank’s current projections for an OCR cut, until the second half of 2025, is more about preventing financial markets getting overexcited about rate cuts in the near term, rather than a genuine indication of what will eventuate. But given the Bank’s recent rhetoric, it would be a brave person to completely rule out the OCR staying where it is, at 5.5% (or above), for another year.