Rate cuts still Bank’s best bet

Central banks around the world continue to face a grim and persistent dilemma. They have poured vast amounts of fuel onto the stuttering flames of the world economy – cutting interest rates, even to negative levels, and flooding markets with new money.

Yet while all this action might have helped to stave off depression, it hasn’t exactly worked perfectly either: growth is tepid in major economies, and inflation is at a crawl, another indicator that the engine is faltering. Another global recession would be a frightening prospect.

The question is: why? The dilemma is: what to do next?

New Zealand faces different but related questions, as Reserve Bank Governor Graeme Wheeler acknowledged last week in a wide-ranging exploration of the difficulties involved with his job.

As with many other countries, inflation is unusually low here – and quite stubbornly beneath the central bank’s target. Economic growth is real but also modest, on a per capita basis. Some asset prices have boomed with all the cheap money, notably houses, but deeper measures of health, like productivity growth, are unimpressive.

Unlike many other countries, however, New Zealand still has room to cut interest rates.

In his speech, Wheeler laid out three schools of thought about whether he should. To paraphrase, one suggests the economy is fine and no further cuts are necessary. Another argues quite the opposite - that the low inflation, and possibility of more growth without serious harm, should precipitate rapid cuts. And a third school of thought, more confidently expressed in recent months, suggests the whole model for when to cut – with its focus on inflation – is broken, and a new one needs to be found.

Wheeler rejects them all and suggests that the Bank will continue its recent trajectory of gentle cuts. Doing nothing might result in ‘‘an economy with less house price inflation, but with a higher exchange rate, slower growth, and lower inflation’’, he said. But cutting too fast ‘‘would likely result in an unsustainable surge in growth, capacity bottlenecks, and further inflame an already seriously overheating property market’’.

This is Wheeler’s idea of the Goldilocks solution, then. He has done a useful job of laying out the landscape and clarifying the Bank’s thinking. He has rightly widened the debate to include important factors like the huge influence of global commodity prices on a small country like New Zealand, and the possible impact of ageing populations on productivity and inflation.

Still, Wheeler has accepted the rationale for more cuts and the real question is just how far to go with them. He is being cautious, but it’s not so clear that deeper cuts are a bad idea. ‘‘An unsustainable surge in growth’’ might sound bad, but it’s not clear why it would be so unsustainable – inflation is low, after all, and the housing boom, while a social disaster, is not an imminent threat to the banking system.

It might be that the sweet spot for the official cash rate is substantially lower even than its current 2 per cent. In other words, potential jobs for the unemployed, higher growth and better living standards could be the price of too much caution.

Caution might have a price.