If the US Federal Reserve needs to do a major rethink, the lows for the NZD/USD might not yet have been reached, writes Cameron Bagrie.

Last month I wrote that “if the United States economy continues to surprise and US inflation remains sticky, exporters might get a chance to lock in the NZD/USD with a five in front of it. That scenario is real and not merely wishful thinking.”

That scenario is now a welcome reality.

The New Zealand economy has played a part. Economic weakness continues to validate the Reserve Bank of New Zealand cutting the Official Cash Rate 50 basis points at the upcoming meeting and moving it progressively towards 3-3.5%.

The main driver, however, has been the US.

Inflation is looking more and more sticky and potentially problematic. The core consumer price index, which excludes food and energy costs, has now risen by 0.3% for the third month in a row. Over the last three months it rose at a 3.6% annualised rate and is up 3.3% compared to October 2023.

Prices for services less energy services, which are watched by the Federal Reserve as gauges on underlying inflation, rose slightly faster (4.8% vs 4.7% in September).

The annual inflation rate in the US accelerated to 2.6% in October 2024, up from 2.4% in September.

Markets nonetheless continue to believe the US Federal Reserve will cut the Federal Funds Rate again before year end. However, they have pulled back considerably on the magnitude over the 12 months ahead.

The moderation in the magnitude of rate reductions in combination with solid economic data has driven the NZD/USD lower. The current national unemployment rate in the United States is 4.1%, which is up slightly from 3.8% a year ago. New Zealand’s unemployment rate has risen from 3.9% to 4.8%. The New Zealand economy is in recession. The US economy expanded an annualized 2.8% in Q3 2024. The Federal Reserve Bank of Atlanta’s GDP Now estimate for Q4 is 2.5%.

A key factor behind the US economy has been productivity growth. Non-farm business productivity has risen 2% in the past year. NZ’s productivity growth is negative.

Strong productivity growth offers the potential for inflation to once again start receding. US economists, all over the data, continue to expect inflation to turn lower again.

However, this can be challenged. There is the reality that the US economy is simply not rolling over. You need the economy to be in a position of excess capacity, which allows or encourages price and wage setting to adjust to a low-inflation economy.

The US Federal Reserve and productivity uplift have done enough to get core inflation in the low 3s. That is not 2%, though. The last few yards were always going to be the most difficult.

Now we have a new president in the US pushing protectionism and tax cuts, potentially adding fuel to inflation when it is already showing stickiness.

The US 10-year Treasury yield has moved from 3.8% to 4.4% in a month. That has dragged longer-term interest rates in NZ higher too.

Financial markets are anticipating 125 basis points of interest rate cuts in NZ and 75 basis points in the US. Markets have removed 50 basis points of easing in the recent month as data has questioned progress getting inflation to 2% and the economic impact of incoming President Donald Trump’s policies is debated.

The case can be made that the US Federal Reserve should not be cutting rates at all.

What does it all mean?

Domestic considerations such as NZ’s excessive current account deficit (6.7% of GDP) requires the NZD/USD to remain in an export friendly zone, which I put at less than 0.65, for an extended period.

The near-term story is USD dictated, and history shows that currencies both undershoot and overshoot forecasts.

Eyes are on upcoming inflation reads in the US over the coming months. If core inflation continues to print around 0.3%, and remains stable around 3.3%, the US Federal Reserve might need to do a major rethink. In such a case, the lows for the NZD/USD might not yet have been reached.

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