Economists and the markets react to the RBNZ's dovish view on the economy and interest rates: Some see chance of rate cut; Wholesale interest rates fall

The Reserve Bank has left the Official Cash Rate on hold and lowered its forecast track for wholesale interest rates, implying the OCR will stay on hold until the June quarter of 2013 and will then only rise slowly, and by around 50-60 basis points to around 3.2% by the end of 2014.

See more in our main article here

Wholesale interest rates fell 6-8 basis points after the release of the June quarter Monetary Policy Statement.

See our Swap Rates interactive chart below.

Here is the economists' reactions below.

ASB economists said they were still sticking to their forecast that the first OCR increase would be in the March quarter, even though the Reserve Bank itself now implied a later start.

ASB also saw the OCR rising to a peak of 4% higher than the 3.25-3.5% peak implied by the RBNZ's 90 day bill rate forecast. However, ASB economists said there was now a one in three chance of a rate cut if the Euro-zone situation worsened.

Westpac's economists saw the Reserve Bank having to hike the OCR four times next year and it was also reviewing its long term potential growth rate.

JP Morgan's economist Ben Jarman said a cut now much more likely than a hike as the Reserve Bank's next move, although overseas events would be the major driver.

ANZ National economists see the OCR on hold until mid-2013 at the earliest.

BNZ's Stephen Toplis said the OCR was likely either to be cut 50 basis points or more if the Euro-zone crisis worsens dramatically or unchanged if Europe 'muddles through'. Toplis said the markets expectations about a small cut in July are likely to be wrong and the Reserve Bank may have to raise rates faster than it forecasts if inflation pressures start building as the economy recovers.

Here's ASB's full comments below:

The RBNZ left the OCR unchanged at 2.5%, as widely expected. The depreciation in the NZD since the April OCR Review means there was little focus on the exchange rate this time around. Instead, as expected, risks from offshore, and particularly Europe, dominate the outlook. The RBNZ has revised down its forecast for Eurozone growth over the next year, although its central projection assumes that the current crisis will be resolved in an orderly fashion. A more significant deterioration in the situation would impact upon world growth and financial markets, meaning an OCR cut would be very likely.

The RBNZ’s interest track now implies a later start to OCR hikes, with the first one coming in Q2 2013 (as opposed to Q4 2012 in the March MPS). This is slightly later than our expectation of a first rate hike in March 2013. However, we still expect medium-term inflation pressures will be slightly stronger than the RBNZ does, and continue to forecast an eventual 4% OCR peak. This is higher than the RBNZ’s implied peak of 3.25% – 3.5%.

Westpac Economists Dominick Stephens and Michael Gordon said they continued to expect the OCR to remain on hold this year and then to be hiked four times through 2013, which is more than the Reserve Bank is expecting.

Here's Westpac's comments in full

The Reserve Bank has left the OCR on hold at 2.5% and reiterates that it remains appropriate to leave the OCR on hold at 2.5%. Overall this Monetary Policy Statement was more hawkish than markets expected, and perhaps slightly more hawkish than we were expecting. The MPS backs our view that the OCR will remain on hold for 2012. We continue to expect the OCR will remain on hold this year and will be hiked four times in 2013.

The outlook for monetary policy was softened slightly. The RBNZ is now forecasting a slightly later start to OCR hikes, perhaps around June 2013. However, the pace of hikes later is faster, meaning 90-day rates are still expected to reach 3.4% by 2015, similar to the previous March MPS.

There was little concession to the idea of cutting the OCR. Indeed the final sentence of the press release  pointed out that the OCR was already stimulatory and was expected to remain on hold: "It remains appropriate for monetary policy to remain stimulatory, with the OCR being held at 2.5 percent."

The RBNZ acknowledged the small but growing risk that "conditions in the euro area deteriorate more markedly...", and discussed how this might impact New Zealand. They noted in this type of scenario, the NZ OCR would probably fall.  

Deteriorating global economic conditions were discussed mainly in the context of falling export commodity prices. However, the RBNZ also noted that some of the decline in dairy prices has been due to strong agricultural production (implying it would be temporary). And it noted that falling export prices had been partially offset by the lower exchange rate.

Discussion of the domestic economy was rather upbeat. Phrases included "housing market activity continues to increase", "reconstruction in Canterbury expected to substantially boost construction activity", and "GDP growth... 3 percent next year." The RBNZ emphasised that monetary conditions have eased, thanks to the lower exchange rate and lower fixed mortgage rates.

Inflation was seen as settling near the mid-point of the target range - another indication that the RBNZ sees the current level of the OCR as on hold. Importantly, the RBNZ has re-thought its opinion of NZ's rate of potential GDP growth (and we are doing the same).

They've basically come to the conclusion that the economy's "speed limit" is lower than previously thought - explaining why inflation is not particularly low despite years of disappointing growth.

The RBNZ’s June Monetary Policy Statement struck the expected tone of acknowledging the deterioration in the global outlook over the last couple of months, while mostly remaining faithful to the broader narrative that shows earthquake reconstruction driving a gradual acceleration in output. Similarly, there were few surprises in the economic projections, with growth marked down (but still picking up pace through this year and next) and the TWI forecasts being pulled down from the low 70s to the high 60s, to reflect the depreciation since the March projections, which represented the high-water mark for NZD.

 

Governor Bollard appears comfortable that the domestic picture is mostly taking care of itself as a construction-led recovery offsets deleveraging by households and the government, with the most dovish tones today reserved for the discussion of external demand conditions. The “small but growing risk” that Europe deteriorates “markedly” means that it is “appropriate for monetary policy to remain stimulatory”. In our view that open-endedness is a concession that looking too far ahead on policy in the current global environment is not advisable, suggesting a neutral policy bias which will last a couple of meetings at least, until the near-term political flashpoints in Europe have been worked through.

The major disappointment of the last few months has been the turn in prospects for the export sector. Domestic dairy producers (the largest export group) have been slugged not only by the worsening growth outlook for key trading partners in Asia, but also a global supply glut, which has pushed world prices lower. That hit to national income has been offset “partially” by the depreciation in NZD, but it remains the case that external conditions will “weigh on economic activity”. So while the remarks from previous statements suggesting NZD is significantly overvalued and may warrant a reassessment of monetary policy settings have been ditched, it still seems the currency is stronger than the Bank would like in the current environment.

 

While the traded sector is being squeezed, the RBNZ’s assessment is that, incorporating the recent discounting of lending rates, monetary conditions overall have “eased significantly”. On top of the 6% fall in the TWI, the fall in domestic swap rates (up to 70bps) and bond yields to all time lows has led to substantial falls in fixed rate loan pricing. Competition in the banking sector within a low credit growth environment has produced yet further easing through negotiated discounts on advertised rates.

 

The Canterbury reconstruction narrative remains largely in place, though there are some subtle acknowledgements that the spillovers from this impulse may not be as significant as earlier imagined. First, it is noted in the MPS that the reconstruction boom, being a geographically concentrated, supply-side phenomenon, need not come with the typical housing boom externalities of wealth effects and exuberant household consumption. To be sure, residential investment accelerates in the RBNZ’s forecasts even “ex-Canterbury rebuild”, but against the broader deleveraging backdrop and low credit use inflation should be much better behaved than in previous housing booms.

 

Also, having been agnostic on government policy for the last few statements, today’s MPS notes that “fiscal consolidation will act as a drag on growth” with “the majority of the projected (Budget) improvement…to come via tighter discretionary policy”. Of course, New Zealand’s has not demonstrated much growth potential in recent years, which makes it unsurprising that, despite still subdued growth and persistent deleveraging drags, most measures of capacity utilization are around average. It seems then that the intensity of tightening required in 2013 and beyond will mostly be determined by the extent of supply side constraints.

 

As far as the near-term data goes, the Bank’s revised projection for 1Q GDP (out next week) is 0.4%q/q, in line with our own forecast. From there, output is assumed to accelerate, to be running at a 0.8-0.9%q/q pace by the turn of next year. Given the substantial downward revisions to the history of GDP released a month or so ago, the capacity of the economy to accelerate in that fashion is far from a lock. However, in what is far from a ringing endorsement for New Zealand’s data quality, it seemed the RBNZ hadn’t placed much faith in the previously upbeat expenditure data anyway, such that “neither measure of GDP is taken at face value in monetary policy considerations”, and the revisions “have not materially affected the Bank’s judgment of inflationary pressures”.

 

Incorporating the mostly dovish tinkering with the commentary, the downward revisions to growth, and the flatter tracking in the 90 day bank bill rate projections, which previously hit 3% by the end of 2012, but now only do so in 3Q13, we characterize this MPS as consistent with slightly slower normalization, even with an unchanged reconstruction timeline for 2013. As long as the possibility of European calamity is front of mind though, next year looks a long way off, and so if a move is to be delivered within the next couple of meetings, we continue to view a cut as much more likely than a hike.

Here's ANZ National's comments:

The RBNZ left the OCR unchanged at 2.5 percent.  The Bank noted that “it remains appropriate for monetary policy to remain stimulatory, with the OCR being held at 2.5 percent.” This is very similar to what they said in April, though without the slightly threatening “for now”.  

The RBNZ’s 90-day interest rate projection was revised down, as expected. The new bill track shows a delayed and more gradual tightening profile, with an end-of-projection rate of 3.4 percent, 20bps lower than in the March MPS. 

The moderation was thanks to a fall in the GDP forecasts, due primarily to a downward revision in export price assumptions.  CPI inflation remains around the middle of the target band throughout the forecast horizon.

Funding costs are assumed to stay high, but the RBNZ note approvingly that NZ banks are very well funded at present.  Global forecasts were little changed, but the downside near-term tail risks are seen to have increased. Trading partner growth is expected to remain “below average”.

The Eurozone crisis remains the unforecastable elephant in the room.  Frustration regarding the strong currency has gone. Indeed, the RBNZ pointed out the downsides of a weaker currency. The bias for the OCR is still up – barring a Eurozone-led meltdown – but not until mid-2013 at the earliest.  We are set for an elongated period of low wholesale interest rates.

Here's comments from BNZ's Stephen Toplis here:

It’s all about Europe. That’s the key message to take from today’s RBNZ Monetary Policy Statement. In short, if Europe muddles its way through, then so too will New Zealand; and the RBNZ will gradually reduce its current stimulatory stance. If not, all bets are off and the RBNZ will drive the cash rate as low as needs be.

As is oft the case, this leaves financial markets pricing New Zealand on the basis of their global views rather than their views as to the performance of the local economy. Having said that, the MPS was a further reminder that, in a very messy world, New Zealand continues to perform remarkably well.

From a domestic perspective, the most important outcome was the acknowledgement by the central bank that New Zealand’s potential growth rate is very low. As we have argued many times, this means inflationary pressures begin to build at lower rates of growth than might have been the case in the past. The Reserve Bank notes that the current potential growth rate is 1.2% and averages only 1.8% for the next three years. This is much lower than the numbers it printed in March.

With the unemployment rate relatively low, difficulty in finding labour rising, capacity utilisation near average, poor net migration outflows and weak recent past investment, it is no surprise to us that the Bank sees the inflationary pressures that it does.

It is worth noting that, since the March MPS, the Bank has significantly lowered its GDP forecasts but that the lowering of its potential expectations has meant its inflation forecasts are largely unchanged. In fact, its CPI inflation trajectory has actually been raised since March though the Bank attributes at least some of this to the recent announcement that tobacco taxes will rise aggressively.

With growth nearing potential, and inflation around the mid point of its target band, it seems entirely appropriate that the Reserve Bank continues to forecast a rising cash rate. Equally, recent softness in both domestic and global economic data provided good cause for the Bank to postpone its intention to raise rates until Q2 next year. This is also our view of the world.

Note that, while the RBNZ has postponed its first rate hike from late this year to next, the overall interest rate track is only modestly lower. By the end point of the forecast period (March 2015) the bank bill rate is just 20 basis points lower, at 3.4%, than forecast back in March.

If there is a difference in our view to the Bank’s it lies with our concern that in order to “equilibriate” growth, potential growth and inflation the cash rate might need to rise even faster than the Bank currently estimates. But there is plenty of time left to argue the toss over this and far too much that might happen in the very near future to get too fixated on the end point.

What one can say, however, is that the swaps market is still priced as if rates will fall. This is a much more dovish outcome than even the central bank’s central case. For financial market players such pricing amounts to taking an option on a European meltdown but for the average borrower what this represents is significant asymmetric risk. If Europe does not implode then lending rates could move aggressively higher just to justify the Reserve Bank’s stance and even more aggressively so, in order to support our own view of the world.

When assessing the Reserve Bank’s reaction to future data it is worth noting that the Bank already assumes growth in both Europe and China turn out lower than the current consensus and that commodity prices fall further. This means the hurdle for an easing is probably higher than at first meets the eye. Moreover, the Reserve Bank is forecasting only 0.4% growth for the economy in both Q1 and Q2. There is probably some upside risk to this.

We thought the Reserve Bank’s view on the Euro region was eminently sane. It noted the risk but, equally, noted that the exact form of any outcome is almost impossible to forecast. Accordingly, it is better for the Bank to keep its powder dry in the event that things do get very nasty rather than offering an “insurance” cut when one has no real clue as to what one is insuring against.

In the event that Europe really does turn ugly then we would expect the RBNZ to react and react aggressively – 25 basis points won’t cut it if Armageddon occurs.

It was difficult to know exactly what the market thought about today’s statement as it was gazumped by news that Moody’s had downgraded Spain three notches to one above junk. This news hit the screens around 20 minutes before the RBNZ announcement (though rumours were rife in the hour before this) and resulted in significant downward pressure on yields across the curve. The NZD also came under downward pressure. Post the RBNZ announcement the currency made up some of its lost ground. This modest appreciation is probably a relatively true reflection that some of the more pessimistic international investors were moderately surprised by the Reserve Bank’s commitment to a tightening bias.

From here, all eyes will be on the Greek elections to be held this weekend. One thing’s for sure, it will create market volatility no matter what the outcome. Whether we will be any the wiser as to what it will all mean for Greece and its membership of the Euro is a moot point. Even more moot will be what it implies for the rest of Europe irrespective of the Greek outcome. And even if we were to work out what it meant for Europe the implications for New Zealand will be far from clear. At this juncture speculation adds little. The best one can do from this distance is watch, wait and be ready to react. This is the case for all whether you are householder, business or bank. In this regard, the Reserve Bank is acting as it should.
 
Closer to home, keep an eye open for Friday’s PMI and Monday’s PSI reports for the month of May. The PMI was surprisingly weak last month so we will be looking for confirmation that the April result was in fact an aberration. The PSI was, in contrast, relatively strong. If both print above the 50 mark then it will be further confirmation that, for now at least, domestic momentum is being sustained.

As things stand, the market is currently pricing a 54% chance of a rate cut at the July 26 meeting and just the one rate cut for the year ahead. It will be wrong. Either Europe implodes and the cash rate will be at least 50 basis points lower than where it is now or it won’t in which case there will be no need for a cut at all. With great trepidation we will stick to the muddle-through scenario that is the Reserve Bank’s central view and make an early call for no change in July or any cut thereafter.

(Updated with ASB reaction, Westpac reaction, JP Morgan reaction, ANZ reaction, BNZ reaction )