Westpac economists say if official interest rate settings are left unchanged next year this will produce economic outcomes "unacceptable" to the Reserve Bank, and they believe the central bank will still be forced take the Official Cash Rate down below zero.
A string of recent positive economic developments, followed by the decision of Finance Minister Grant Robertson to write to the to RBNZ proposing that the central bank consider the impact its monetary policy has on house prices has been seen by the market as drastically reducing the chances that the OCR will be taken below zero.
Previously it had been largely seen as a given that the OCR would go minus next year, but things such as the rampant recent housing market, plus the $28 billion Funding for Lending Programme just launched by the RBNZ have seemingly reduced the need for an OCR below zero.
In their Weekly Economic Commentary, the Westpac economists say financial markets now think that further OCR cuts are "unnecessary".
"However, we disagree," they say.
"We have run an assessment of what would happen if the Reserve Bank kept monetary settings unchanged next year.
"Inflation would be significantly lower than otherwise and would remain below 2% for much longer. Inflation expectations would drop even further, raising the risk of deflation. Unemployment would remain higher for longer. And the exchange rate would rise into the mid-to-high-70s against the USD."
The economists say these outcomes "would be unacceptable" to the RBNZ.
"The only silver lining would be a slower and more drawn-out episode of house price inflation, but that wouldn’t be enough to compensate for the extra unemployment and risk of deflation."
The economists acknowledged the recent letter from Robertson to the RBNZ asking it to consider excessive house price volatility within its remit.
"But we think that this development will only manifest in a more cautious Reserve Bank, rather than a change away from the Bank’s inflation focus. In other words, we think that the Reserve Bank as it moves to take into account housing as part of its remit will then deliver slower and later cuts in the OCR."
The Westpac economists now expect just two (previously they forecast three) 25 basis point OCR cuts, with one in each of May and August 2021, taking the OCR down to -0.25. Previously they forecast a low of -0.50%.
"We have long been of the view that reducing the OCR below zero would be the Reserve Bank’s unconventional monetary policy tool of choice, after the expiry of the one-year commitment to keep the OCR at 0.25%."
However, the economists do say while they still think a negative OCR is more likely than any other tool, they do see other options that "now look like more of a possibility".
"With the exchange rate set to rise much higher than we previously anticipated [they now forecast to US74c by the middle of 2021], adding foreign bonds to the Large Scale Asset Purchases programme (which would directly reduce the exchange rate) is starting to look more like a sensible alternative option. The other advantage is that foreign bond purchases don’t have an obvious “front page” link to the housing market.
"Another alternative option would be for the Reserve Bank to expand the Funding for Lending Programme (FLP) further. The advantage would be that the FLP is already an established tool, so there is less risk of unanticipated consequences. But we are not convinced that increasing the size of the FLP would have much effect on interest rates – it is more the presence of any FLP that is going to cause term deposit rates and wholesale funding rates to come down, thereby reducing bank funding costs."