Are recent interest rate cuts actually a silver lining?

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Are recent interest rate cuts actually a silver lining?.

Larry Williams:
David, the Reserve Bank has now cut the Official Cash Rate twice in consecutive meetings. What does this tell us about the shape of our economy?

David McLeish:
It's of course a truism that for the Reserve Bank to feel that they need to cut the Official Cash Rate twice in succession that the outlook they have for our economy must be less than rosy.

Now while that's an obvious conclusion to make, especially with the well documented uncertainties we face around dairy prices, a peak in Christchurch construction etc, what it misses though is the fact that New Zealand still has the ability to cut its overnight cash rate. Strange as this once would've sounded, much of developed world no longer has this option, simply because they have already reached the zero bound.

Larry Williams:
So what you're saying is that there is a silver lining?

David McLeish:
Right. Again the obvious silver lining is that yes, the future is uncertain, but by lowering our cash rate it puts more money in the pockets of borrowers. This in turn tends to encourage spending and investment. It also typically has the effect of lowering the value of our currency which will make our exports cheaper to overseas buyers. These are likely to help stimulate the economy and help offset the headwinds we face.

The less obvious silver lining is that by having an Official Cash Rate up at 3% the Reserve Bank can be proactive, in essence staying in front of the uncertainty ahead. We think this is what they are doing right now.

Larry Williams:
You mentioned we compare favourably against many other countries in terms of our cash rate. What are those countries doing if they don't have the ability to cut their interest rate like us?

David McLeish:
Some have gone one, or in some cases many, steps beyond conventional monetary policies — such as adopting negative deposit rates and/or launching huge money printing programs. However, most have had limited success in creating sustainable growth. The obvious conclusion here is that unconventional policies have far less impact on an economy than many had hoped for.

Again this is why still having old-school, conventional methods at your disposal in order to stimulate your economy puts you at a distinct advantage in my opinion.

Larry Williams:
There has been a lot of talk around the U.S. Federal Reserve possibly raising their cash rate later this year. Is their economy really that strong to justify a higher interest rate?

David McLeish:
That's a great question Larry. The short answer is no.

Putting ourselves in the shoes of Janet Yellen, the Chair of the Federal Reserve, for just a minute shows the predicament she faces. And before you ask, I'm not suggesting that I'd look at all good in a pair of her shoes.

Anyway, the best way to demonstrate my point is to compare New Zealand's current economic situation with that of the U.S. Given that one is cutting rates and the other is expected to be raising rates shortly, the differences should be obvious to all.

U.S. GDP growth is currently running at 2.4% p.a. while New Zealand's is 2.6%. Now the trend is of course important and in that respect New Zealand's growth rate has weakened recently. But the U.S growth rate has not done much better, in essence flat-lining for over four years now. It's also worth mentioning that both central banks are forecasting approximately 3% growth for their respective economies in the year ahead.

Inflation in the U.S. is running at just 0.1% year-on-year. While also low, New Zealand's is again marginally higher at 0.3%. Remember the job of both central banks is to target 2% inflation over the medium-term.

Now I know the forecasts for the two economies is more divergent than that but it's also true that the Federal Reserve has for years now over-estimated the growth and inflation outlook for the U.S. economy. What I take from all this that the New Zealand is choosing to be proactive to the hurdles that lay ahead while the U.S. is simply hoping its economy can handle higher interest rates.

Larry Williams:
So why do you think it is that they are so keen to raise their cash rate then?

David McLeish:
At some point there will be another recession in the U.S. If the Federal Reserve does not get their cash rate off of 0% sometime soon they will find themselves entering the next downturn in the unenviable position of not having any conventional monetary firepower to ward off the deflationary effects it will bring.

For them, it's matter of need rather than want.


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