By Alex Tarrant
The Reserve Bank has left the Official Cash Rate unchanged at 2.50%, noting in its December quarter Monetary Policy Statement that inflation and growth are expected to pick up over the medium term.
The Bank left its outlook for base interest rates unchanged from September, indicating a possible 25 basis point OCR hike in early-mid 2014.
However it did note that it expected retail rates offered by financial institutions to be lower than it thought in September. It noted lower funding costs for banks, and increased competition for lending as factors that had driven mortgage interest rates lower.
“Economic growth has slowed in recent months and has been accompanied by low inflation and rising unemployment, Governor Graeme Wheeler said in a statement accompanying the MPS.
“However, over the next two years, growth is expected to accelerate to between 2.5 and 3 percent per annum,” he said.
The global outlook remained soft but appeared less threatening than was the case earlier in the year.
“The risk of severe near-term deterioration in the euro area has decreased and Chinese economic indicators have been more positive recently. However, uncertainty around the US fiscal position is constraining US growth,” Wheeler said.
Wheeler noted repairs and construction activity in Canterbury continued to gather pace, and that the housing market was strengthening, particularly in Auckland.
Lower funding costs for New Zealand banks, along with increased competition for lending, had seen mortgage interest rates reduce.
“The overall outlook is for stronger domestic demand and the elimination of current excess capacity by the end of next year,” Wheeler said.
“This is expected to cause inflation to rise gradually towards the 2 percent target midpoint.
“Monetary policy remains focussed on keeping future average inflation near the 2 percent target midpoint. The Bank is closely monitoring indicators for any sign of further moderation and is mindful of recent downside surprises to employment and inflation outturns,” Wheeler said.
“With the reconstruction-driven pick-up in investment now clearly underway, the Bank will also continue to watch for a greater degree of inflation pressure than is assumed,” he said.
“On balance, it remains appropriate for the OCR to be held at 2.5 percent.”
Lower retail rates
The Reserve Bank’s 90-day bank bill track (generally 20-30 basis points above the OCR) was largely unchanged from September, with the only tweak the projected shift from 2.7% to 2.8% pushed back from the December 2013 quarter to the March 2014 quarter.
From there, the Bank projects the 90-day rate to rise to 2.9% in the June 2014 quarter (previously 3.0%). Projection for the September 2014 quarter through March 2015 remained unchanged at 3.1, 3.2 and 3.3 percent, respectively.
Given current economic headwinds, and current low inflation, monetary policy was expected to remain “supportive throughout the projection horizon,” the Reserve Bank said in the Monetary Policy Statement.
“The 90-day interest rates projection is unchanged from September. Nonetheless, because of lower bank funding costs and increased competition among banks, this projection implies a lower forecast for retail interest rates than was the case in the September statement,” it said.
In the Monetary Policy Statement, the Reserve Bank noted how annual Consumer Price Inflation had fallen below its 1-3 percent target band in the September 2012 quarter.
It said that, in part, low inflation over the past year related to one-off movements that were “unlikely to persist.” An example was falling fruit and vegetable prices, related to recovery from the early-2011 Queensland floods.
Inflation was expected to move back within the target range in the December quarter.
However, much of the move down in inflation seemed to indicate a more persistent reduction, the Bank said.
“Most measures of core inflation have fallen to the lower part of the target band and inflation expectations have moderated. The Bank continues to closely monitor indicators for any sign of further moderation in inflation and is mindful of recent downside surprises to its inflation forecasts,” it said.
That said, it was also important for the Bank to watch for any sign of a turning point, given the coming reconstruction-driven pick-up in investment activity, it said.
The Bank had revised upward its forecast for rebuilding activity to about NZ$30 billion, with about NZ$5 billion expected to occur within the projection horizon to March 2015. Relative to its September projection, the extra building activity was assumed to occur later this decade, so had limited impact on monetary policy for the next few years.
The Bank also noted recent building consent and housing turnover data suggested underlying residential investment would rise in the near term.
The Reserve Bank said house price inflation continued to accelerate in some regions, particularly Auckland.
“The Bank does not expect this pick-up to substantially increase generalised inflationary pressures,” it said.
“House price inflation is expected to moderate, with house prices already very high. Furthermore, given household focus on consolidation, it is unlikely that the current pick-up in house price inflation will have the flow-on impact to household spending that was seen through the mid-2000s.
“That said, there is a risk that house price inflation does accelerate further, particularly if supply is constrained by continued low residential construction. Excessive house price inflation would be concerning both from an inflation targeting and financial stability perspective.”
We continue to see the RBNZ first lifting the OCR in September, ahead of the RBNZ’s implied 2014Q1 start
The RBNZ expressed some concern about slowing momentum in the NZ economy, noting some of the weaker activity indicators in recent months. Nonetheless, it points to the recent Quarterly Employment Survey, QSBO, building consents and the Performance of Services Index results as indicative of continued GDP growth. While the RBNZ has revised down its growth forecasts for the coming year slightly, beyond 2013 it now expects stronger growth. A key part of this upward revision is its expectation that residential investment will now be stronger in light of its upward revision to the cost of the Canterbury rebuild. The RBNZ now estimates the cost of the total cost of the rebuild at $30 billion, up from its previous estimate of $20 billion. However, the full extent of the upward revision is not reflected in the December MPS forecasts, given the RBNZ assumes that much of the extra building activity will occur later this decade (beyond the RBNZ’s projection horizon).
The RBNZ appears to be more wary of the strength in housing market activity in recent months, highlighting the continued acceleration in house price appreciation – particularly in Auckland. While the RBNZ is mindful of the risks of excessive house price inflation on inflation and financial stability, for now it expects the continued focus by households to pay down debt will mute the flow-on effects to household spending. The RBNZ also expects fiscal tightening to dampen demand in the NZ economy over the coming years.
We have a slightly stronger growth outlook relative to the RBNZ over much of the projection period, largely reflecting our stronger net export outlook.
International outlook: soft, but less threatening
The RBNZ’s view on the international outlook appears to have improved marginally since September. The Statement notes that “the global outlook appears less threatening than was the case in September.” A large part of the improvement, in the eyes of the RBNZ, has been in the euro area, where “the risk of a severe near-term deterioration…appears to have decreased.” The ECB’s Outright Monetary Transactions policy is praised as a “credible backstop to troubled European nations.” Meanwhile, comments on the US fiscal cliff are kept relatively brief; the RBNZ notes that “a positive outcome to the budget negotiations is expected”, but that draw-out bargaining may be a source of increased financial market volatility going into year-end.
In terms of the trading partner growth outlook the RBNZ’s views have not changed materially, and the Bank remains comfortable that NZ’s main trading partners, Australia and the Asian economies, maintain a relatively robust outlook. While noting that growth in Asia has slowed over the past year, Chinese policy measures intended to re-accelerate growth are described as “successful,” given the pick-up in quarterly GDP growth. Comments on Australia were kept very brief, with just a passing nod to the subdued state of the non-mining sectors of the economy but an acknowledgement that “Australia is expected to grow at around average rates over the forecast period.” Expected growth rates in the euro area and the US are described as “weak” and “moderate” respectively.
Inflation: focus on the medium term
As expected, the RBNZ revised its near-term inflation forecasts lower, reflecting weaker-than-expected outcomes and a higher outlook for the NZD. The RBNZ remains mindful of the near-term weakness in inflation, particularly with core measures tracking toward the lower half of the band. Nonetheless, the Bank continues to see inflation pressures lifting over the medium term. The RBNZ noted pockets of pricing pressure emerging related to the housing market. It explicitly noted the upside risk to medium-term CPI inflation from the wealth effects of excessive house price inflation.
There was also increased concern around the increase in Canterbury construction inflation. The RBNZ is concerned about spillover to the rest of the country, although this has yet to flow-through to nationwide construction inflation. This is another area the RBNZ will continue to monitor closely. We continue to see stronger medium-term inflation than the RBNZ is forecasting.
We continue expect the RBNZ to keep the OCR on hold until the September MPS, though acknowledge the RBNZ is indicating early 2014 in its forecasts. We do see the earthquake rebuild and housing as driving medium-term inflation higher than the RBNZ currently assumes. The hotter parts of the inflation outlook – construction (in particular) and housing – are showing more tangible signs of heating up. The RBNZ is now placing more emphasis on these factors, and we expect they will become an increasingly bigger part of the RBNZ’s policy decisions next year. Note that the RBNZ is now expressing concern about the housing market from both an inflation targeting and a financial stability perspective. The supply imbalance in Auckland and persistently-low interest rates suggest those concerns will be with the RBNZ a while longer yet.
Two factors suggest that the RBNZ is not seriously contemplating an OCR cut in the near term. The balance of inflation concerns remains on the medium term. Importantly, the RBNZ is now incorporating a stronger NZD outlook for longer (and the impact of that on the inflation outlook). These factors were baked into the MPS outlook and considerations with little impact on the RBNZ’s interest rate outlook. Accordingly, we have reduced our probability of an OCR cut over the next year to 20%, from 30%. Global threats remain, but the domestic threshold is slightly higher relative to the October Review. Market pricing has pulled back to around 15bp of OCR cuts priced in over the next year, from 25bp prior to the announcement, a more appropriate balance of the risks.
NZ interest edged up across the curve in light of the more upbeat RBNZ statement as markets reduced the probability of an OCR cut over the coming year. The one-year swap rate increased around 9 basis points in the hour after the statement release, while the five year increased 6 basis points.
Similarly, the NZD appreciated following the statement release, with the NZD/USD now around 0.8280 – up from 0.8255 prior to the statement release.
The Reserve Bank kept the official cash rate unchanged and firmly reiterated its "on hold" bias for monetary policy with a simple bottom-line sentence:
"On balance, it remains appropriate for the OCR to be held at 2.5 percent" .
The 90-day interest rate forecast indicated that the RBNZ expects to begin increasing the OCR from March 2014.
For markets, this was a "hawkish" statement. It gave no encouragement whatsoever to the idea that the next move in the OCR might be downwards.
The statement was very much along the lines Westpac was expecting.
The main messages were broadly unchanged from previous missives. The global economic situation has improved but remains risky. Local economic growth has slowed and inflation is low, allowing the RBNZ to keep the OCR on hold (although the recent jump in the official unemployment rate was largely dismissed as a statistical aberration). But this weakness was seen as backwards-looking. The outlook is for the Canterbury rebuild to apply inflation pressure and eventually require modestly higher interest rates. In the Reserve Bank's words:
“The overall outlook is for stronger domestic demand and the elimination of current excess capacity by the end of next year. This is expected to cause inflation to rise gradually towards the 2 percent target midpoint."
As we suspected, the discussion of risks was skewed. The MPS contained a box titled "the implications of an excessive buildup in house price inflation" which said that if house prices keep rising and household credit growth accelerates the RBNZ could respond by increasing the OCR. We expect the housing market will indeed remain buoyant, and therefore we expect the OCR to begin rising from September next year.
Significantly, the RBNZ updated its estimate of construction activity associated with the Canterbury rebuild from $20bn to $30bn. So although the RBNZ's near-term GDP forecast had been downgraded, the GDP outlook was upgraded from 2014 onwards.
Markets have long been flirting with the notion that the RBNZ might reduce the OCR, encouraged by a slew of weak data and the change of Governor. The RBNZ's commentary today emphatically reiterated that the RBNZ expects the next move in the OCR to be upwards. The initial market reactions were +9bp in the 2yr swap yield and a 25 pip lift in the NZD/USD exchange rate. Looking ahead, markets could extend the jump in NZD/USD to 0.8300 today, 2yr swap yields by an additional 5bp to 2.70%. The 2-10yr swap curve should flatten towards 100bp, and swap spreads should firm slightly.
The Official Cash Rate (OCR) was left unchanged at the record low of 2.5% as widely expected. But today was about the extent to which the RBNZ under Governor Wheeler was prepared to signal to the markets about the future direction of monetary policy via changes to growth forecasts and the bank bill profile.
The doves were not only left empty-handed but were belted out of the park. There is a refreshing approach from Governor Wheeler in looking ahead “over the next two years”, only slightly nodding to recent weak reports on retail sales and employment. Also, the global outlook was upgraded from ’fragile’ to ’soft’ and appears to be overall ’less threatening’. The Governor's Policy Assessment is over the page, with TD comments and clarifications.
The strongest language was reserved for domestic demand, particularly housing. The highlight is “the housing market is strengthening” which is also an upgrade from October’s “activity is increasing”. The Bank estimates that Canterbury construction costs are approaching double-digit (+9.6%/yr), a worrying leading indicator for overall inflation.
The “elimination of current excess capacity by the end of next year” introduced output gap analysis to the Bank’s thinking, a concept somewhat absent during Dr Bollard’s regime. The debate for 2013 should swiftly turn to how the stance of monetary policy should be set at the time the output gap closing. Growth has been below trend for so long (RBNZ estimates potential output as 2.1% for March year 2014) that a debate about what is a neutral cash rate is long overdue.
The Bank’s GDP forecasts remain uncontroversial and similar to TD at 2½-3% for 2013 and 2014 (March years) while the bank bill forecasts remain unchanged at 2.7% until end-2013, but added +60bp of tightening over 2014.
Market reaction—shock—and more to come
The hawkish stance taken by Governor Wheeler was immediately reflected in the bond and currency markets. The NZD surged from $US0.825 to $US0.829 on the strong language, currently $US0.828. We suspect as other markets open the NZD is set to outperform on the crosses also, especially the AUD (our favourite theme all year). The NZD looks like overshooting our year-end target of $US0.82, and we maintain our end-2013 target of $US0.83.
The bond market reaction was similarly sharp, with 2yr swap yields up +8bp to 2.67% and 10yr bond yields +3bp to 3.54%, for a flattening of the curve. We expect the 3-10yr bond curve to flatten further from the current +106bp to closer to +80bp by end-2013. Trade idea: pay NZ 12m OIS … lot of re-pricing to do there.
Change of view
We were always alert that our view of the first OCR tightening by +25bp in March 2013 was controversial and redundant, but we needed this report from the RBNZ before assessing the appropriate the timing. As the hurdles for tightening aren’t that high in our view, we merely push out the timeframe from March to June (for a year end OCR of 3.25%) still aggressive compared with consensus recently slipping from September to October. It’s clear to us that domestic conditions will be dictating the timing of the first cash rate increase, and the construction boom underway is set to provide upside pressure to inflation in due course.
2013 will finally be interesting for G10 rates space, with our view of New Zealand, Canada and Norway likely to start gently taking the foot off the accelerator. After today’s communiqué, we remain convinced that the RBNZ will be the first cab off the rank.
Policy Assessment [TD comments].
Economic growth has slowed in recent months and has been accompanied by low inflation and rising unemployment. However, over the next two years, growth is expected to accelerate to between 2.5 and 3 percent per annum. [Wheeler is looking ahead, not behind, as he should be!]
The global outlook remains soft but appears less threatening than was the case earlier in the year. The risk of severe near-term deterioration in the euro area has decreased and Chinese economic indicators have been more positive recently. However, uncertainty around the US fiscal position is constraining US growth. [prior was “remains fragile” so an upgrade]
Repairs and construction in Canterbury continue to gather pace, and the housing market is strengthening, particularly in Auckland [prior ‘activity is increasing’]. Lower funding costs for New Zealand banks, along with increased competition for lending, have seen mortgage interest rates reduce.[new for Wheeler, i.e. capital markets have loosened up]
Dampening factors include the Government’s fiscal consolidation and continued cautiousness by households and businesses in their spending decisions. The high New Zealand dollar continues to be a significant headwind, restricting export earnings and encouraging demand for imports.[same message, different wording to October]
The overall outlook is for stronger domestic demand and the elimination of current excess capacity by the end of next year. This is expected to cause inflation to rise gradually towards the 2 percent target midpoint. [stronger demand language, first mention of output gap in years]
Monetary policy remains focused on keeping future average inflation near the 2 percent target midpoint. The Bank is closely monitoring indicators for any sign of further moderation and is mindful of recent downside surprises to employment and inflation outturns. With the reconstruction-driven pick-up in investment now clearly underway, the Bank will also continue to watch for a greater degree of inflation pressure than is assumed.[additional emphasis on the 2% target, nod to recent weakness, but the rest of the statement is looking ahead]
On balance, it remains appropriate for the OCR to be held at 2.5 percent. [dropped the ‘for now’ but a mistake to complacently assuming low for longer, consensus is +25bp in October 2013]