BNZ's Stephen Toplis says case growing for OCR cut; 'Not BNZ's central forecast, but is it plausible? Hell yes'

By Alex Tarrant

The case for an Official Cash Rate cut is growing, BNZ head of research Stephen Toplis says.

"For some time now, financial markets have been pricing in a relatively high probability that the Reserve Bank of New Zealand would lower its cash rate. We have been staunchly opposed to that view largely because we felt markets were failing to differentiate between what was going on in New Zealand compared to what was happening around the rest of the world," Toplis said.

"Now, however, domestic indicators have turned sour and we believe the time is ripe to contemplate the very real possibility the RBNZ could pull the trigger. Is it our central forecast? No. Is it plausible? Hell yes."

There was no doubt the economy was currently going through a soggy patch.

"There is no question that the majority of data are surprising on the downside. There is equally little doubt that (a) the central bank will be forced to lower its inflation forecasts and (b) will likely need to present a less aggressive interest rate track. It may even go so far as to speculate on what it would take for it to lower the cash rate," Toplis said.

"That said, we are hanging, by our fingernails, to the view that the economy is far from dead and does not warrant extra monetary support. Housing is robust, business confidence portends trend growth, credit aggregates are edging higher, global demand is stabilizing, commodity prices are rising, and consumer confidence is holding up," he said.

"Indeed, it is conceivable that in the current environment any further monetary policy support might ultimately prove counterproductive."

"But we concede that we are nervous and folk are right to ponder whether a cut might be appropriate. We have no doubt this very question will also be asked within the walls of the Bank.

"And, if the data continue to deteriorate, it is entirely plausible that the Bank will feel the need to swing into action. For the first time this year we accept that it is now appropriate for the market to price in some chance of a rate cut at the next meeting even if the 30% presently priced seems a tad overdone," Toplis said.

"Similarly, while our core view is that the currently priced 100% prospect of a future rate cut may be inappropriate it is entirely conceivable that the market might move toward pricing more than one cut in the event that the RBNZ shows any sign of allowing interest rates to fall when it produces its 6 December statement," he said.

Read Toplis' full comments below:

For some time now, financial markets have been pricing in a relatively high probability that the Reserve Bank of New Zealand would lower its cash rate. We have been staunchly opposed to that view largely because we felt markets were failing to differentiate between what was going on in New Zealand compared to what was happening around the rest of the world. Now, however, domestic indicators have turned sour and we believe the time is ripe to contemplate the very real possibility the RBNZ could pull the trigger. Is it our central forecast? No. Is it plausible? Hell yes.

It’s worth reminding all that the RBNZ has the exclusive mandate of targeting annual CPI inflation within a 1.0% to 3.0% target band. That commitment has recently been upgraded in the newly-signed Policy Targets Agreement to a focus on the mid-point of that band. What the Reserve Bank thinks about future inflation is thus the be all and end all of monetary policy. So, with the RBNZ’s September MPS revealing forecast inflation to soon rise to the middle of that band, predicated on the cash rate rising slowly from late next year/early 2014, there has been, prima facie, little reason to talk about easing unless, of course, the Bank has been provided good reason to change that forecast. Herein lies the crux of the matter. It probably has.

To start with, the Q3 CPI outturn turned out lower than the Bank had anticipated at 0.3% rather than the 0.5% forecast. The quarterly outturn, in itself, is of no great consequence. What is, though, has been a general tendency for the RBNZ to be surprised on the downside over the last year or so. Indeed the Bank has underestimated every one of the last five inflation outcomes. This will have the folk down at the Bank pondering why this might be so and posing the question that if a systematic bias has developed that inflation might in fact end up languishing below the mid-point of its band for some time to come. Moreover, with petrol prices plummeting through Q4 it already looks as if Q4 CPI inflation will again print well below the Bank’s 0.5% pick. We are forecasting 0.2% in a quarter (with downside risk) which has a track record of surprising all and sundry to the downside. After all, three of the last four December quarters have printed negative. We’ll have to wait until mid January to find out the truth of the matter but the potential for surprise is clear.

The impact of these changes should not be underestimated. If, for example, the Bank decides it has got a bias its forecasts of 0.1% per quarter then adjusting for this and recent petrol price movements alone could see their annual inflation forecast drop to 1.3% one year hence. That would be two years of sub-2% inflation.

There are two aspects to the low CPI numbers. Not only do they bring into question the future forecasts but also the low published numbers will tend to force inflation expectations downwards which, in turn, will help subdue future inflation. Annual CPI inflation is currently at a meagre 0.8% and, if our own forecasts are correct, will stay sub 2.0% until at least Q4 of next year.

Perhaps the most important aspect of inflation surprising on the downside is that, all other things being equal, it suggests the amount of spare capacity in the economy (the output gap) is greater than the Bank had assumed. This is important as it implies that the economy can grow stronger for longer without creating inflationary pressure.

And whatever the case on this front, spare capacity is clearly greater than expected to the extent that the unemployment rate recently printed miles above RBNZ expectations – 7.3% versus 6.7%. So, again, the starting point suggests much more room to grow without generating inflation. Moreover, the widening gap between employment and GDP growth intimates a surge in productivity that could only be disinflationary.

As if all this stuff wasn’t enough, the exchange rate refuses to roll over and die. Despite a string of relatively weak data the TWI still sits at 72.8 against an RBNZ expectation that it would average 72.0 through the December quarter and 71.7 in Q1 2013. The expectation and outturn are very close but ongoing strength in the NZD could yet sneak another point or two off annual inflation forecasts.

Putting all this together, one can only conclude that the RBNZ’s inflation forecasts must be lowered relative to those published in its September Monetary Policy Statement. This, from a consistency perspective, must then leave the Bank with four options:

-        Further delay its printed tightening cycle;

-        Remove the tightening altogether;

-        Move to an easing bias; or

-        Cut rates.

The argument for a cut is, we accept, very strong but we just don’t believe that it would be the right thing to do just yet.

Perhaps most important, in this regard, is the fact that a drop in interest rates is unlikely to provide the medicine that is required for the ailing economy: it won’t bolster Australian demand; it probably would have little impact on the exchange rate; and it is unlikely to boost consumer or business spending because the level of interest rates is providing no hurdle in these areas.

In contrast, a drop in interest rates might just pour further fuel on a housing market which is showing the first signs of speculative fervour - the last thing anyone wants or needs, at this stage in the economic cycle.

Some folk have concluded that the new Governor Graeme Wheeler is new to the job so would be reluctant to move rates and that he is more hawkish than his predecessor so would need a higher hurdle to respond. There may be an element of truth in these comments but we would strongly downplay their importance.

Wheeler appears to be a very “orthodox” macro-economist. He’s had enough time to get his head around all the local issues and will just be looking to the RBNZ’s current forecasting round to fine tune these views. He wouldn’t be in the slightest bit reluctant to move rates at this stage if the data and forecasts suggested this to be an appropriate response. Moreover, hawkishness is a relative concept. He might be more hawkish than Alan Bollard was but this doesn’t mean he would fail to jump when conditions demanded it.

There is no doubt the economy is going through a soggy patch. There is no question that the majority of data are surprising on the downside. There is equally little doubt that (a) the central bank will be forced to lower its inflation forecasts and (b) will likely need to present a less aggressive interest rate track. It may even go so far as to speculate on what it would take for it to lower the cash rate.

That said, we are hanging, by our fingernails, to the view that the economy is far from dead and does not warrant extra monetary support. Housing is robust, business confidence portends trend growth, credit aggregates are edging higher, global demand is stabilizing, commodity prices are rising, and consumer confidence is holding up. Indeed, it is conceivable that in the current environment any further monetary policy support might ultimately prove counterproductive.

But we concede that we are nervous and folk are right to ponder whether a cut might be appropriate. We have no doubt this very question will also be asked within the walls of the Bank. And, if the data continue to deteriorate, it is entirely plausible that the Bank will feel the need to swing into action. For the first time this year we accept that it is now appropriate for the market to price in some chance of a rate cut at the next meeting even if the 30% presently priced seems a tad overdone. Similarly, while our core view is that the currently priced 100% prospect of a future rate cut may be inappropriate it is entirely conceivable that the market might move toward pricing more than one cut in the event that the RBNZ shows any sign of allowing interest rates to fall when it produces its 6 December statement.