Opinion: Now some work to be done

By BNZ Markets' Stephen Toplis The secret to good central banking is to create an environment where, by and large, everyone knows what you are up to and where you are headed. Occasionally, you are called upon to nudge thinking in the "right" direction when folk have started to get the wrong end of the stick. An important corollary to this is that financial market pricing becomes less volatile and people can make decisions with increased certainty. With this in mind, market pricing and general sentiment had been almost unanimous in expecting a 25 point cut in the cash rate today with more to come thereafter. To have delivered this would have made an awful lot of sense and if the Bank had wanted to front load its easing, as it has suggested today, it would have been easy to confirm the likelihood of further substantial easing ahead. This could have delivered a very similar real economy outcome but had a wildly different impact on expectations and credibility. Bear in mind that as the Bank's forecasts currently stand, there appears to be only one further easing priced in before the end of the year. What's more only one more is forecast for 2009 and one last one in 2010. That being the case it seems very strange that you would slash rates 50 basis points and then, in the not too distant future, publish a pause in the easing process. This seems too clever by half. The problem, though, is that no-one is going to believe this. The market, for example, has 50 basis points of further easing priced in by the end of the year and desperately wants to price in another cut. Moreover, a large number of commentators, particularly those sitting offshore, are becoming increasingly convinced that a further 50 basis points is on offer for October. Given the Bank's actions today, that's a rational view to take. Moreover, in interviews post the MPS Alan Bollard did little to moderate this assumption. It's not our pick but you can't knock it. Is this really the impression the RBNZ wanted to create? Surely not, else its forecasts would not be as they are. For what it's worth, we believe that there's a greater than even chance of a further 50 basis points of easing before the end of the year. We are rating the probability of a 25 basis point cut in October at 70%, with a 20% chance of 50bp and 10% chance of nothing. Given an October rate cut December is then 55/45. This leaves our end year forecast 25 basis points lower than was previously the case at 7.00%. We have to concede we are gob-smacked by today's decision, and we were wrong! The only consolation was that we were in good company and, we think, equally good company in not knowing what the Bank's up to from here. Indeed, one can't be expected to have too much clarity when in response to a media question as to what the Bank might do in October the Governor replied "we don't know"! Surely a more appropriate response would be along the lines of: "if things pan out as we expect then the door will remain open to further easing" or something similar. "We don't know!" hardly breeds confidence does it? Mind you, if you think that's a dopey line, the journalist who asked Bollard "if he had considered lowering rates by 50 basis points" surely won the prize for silliest thing said on the day. The other thing that has bred confusion is apparent inconsistencies in the Bank's Monetary Policy Statement. The most glaring of these is in reference to the interest rate track. In the Bank's summary it says: "we have brought forward some of the projected interest rate reduction, but have not altered the expected overall decline." The published forecast track, however, now troughs with two less rate cuts than was previously the case. For the record, the Bank has the 90-day bank bill rate low at 6.8% which implies a cash rate of 6.50%. We actually believe that, in due course, the cash rate will fall below this level. However, we suggested in our MPS preview that we were looking to raise the low in our track from 5.5% to 6.0% and put in a couple of pauses in the rate cut profile along the way. There was nothing in today's statement to alter that view so we have shifted accordingly. Note, that the placement of the pauses is indicative only and not a strong view on timing, which will clearly remain in a state of flux. We should note that the primary reason for this shift is our expectation that inflation expectations will be anchored at 2.5% rather than the 2.0% one would hope for from a 1.0 to 3.0% target band. Indeed, there is a very real risk that we might need to add another 0.5% taking the OCR low to 6.5%, if inflation expectations settle at their current 3.0%. This is highly possible given the inflation track that the Reserve Bank itself has published which sees inflation hanging up near the 3.0% mark for some time. In part this is a function of the Emissions Trading Scheme that was passed into law today and the Bank can be forgiven for having to deal to the inflationary impacts of this. More disturbing, however, is the fact that even at the trough of the economic cycle, forecast inflation only just gets down to 2.0%. One would have expected a figure closer to the lower bound of the band following the worst recession to hit the economy in almost two decades. This aside, with short term interest rates now lower than we had previously assumed, we have also given our currency track a bit of a nudge to acknowledge this lower than expected starting point. Not surprisingly, the NZD tumbled today losing a cent against the USD and falling to 62.74 on a TWI basis. This puts the TWI 1.5% below where the RBNZ has assumed it to be for the first half of next year. In our opinion, it's only going to go one way from here. This could yet prove problematic for the RBNZ though, so far, it appears fairly relaxed with the demise of the NZD. So why did the Bollard pull the plug in the manner that he did? In short, he has been spooked by a combination of faltering global growth and the impact of the credit crisis "“ and for very good reason. Importantly, the Reserve Bank ditched its normal policy of using Consensus Forecasts for global growth and adopted a lower profile. The last time this was done was during the Asian crisis and that proved entirely appropriate. We think it's appropriate this time too. On the credit crisis front, the RBNZ is cognisant that it needs to cut rates by more than might have been the case previously in order to get bang for its buck. Indeed Alan Bollard went so far as to say he wants to see mortgage rates fall. We suspect that he is going to get his wish with Kiwibank already leading the fray. We note, nonetheless, that given credit conditions, rate reductions will hurt the banking system as the cut in the cash rate will barely dent the cost pressures coming from rising international funding costs. We are quick to point out that we have little difficulty with the Reserve Bank's general forecast profile, which has actually moved closer to our own. However, what we do have difficulty with is in understanding the message the Bank is trying to deliver on the likely policy response. For the sake of its own credibility, there is now some work to be done. ------------------ *This Economy Watch Report was written by BNZ Markets' Stephen Toplis. All of the research from the BNZ Markets team of economists is available here.