David Hargreaves says it might be in everyone's best interests if the Reserve Bank finds a less blunt way of communicating its thoughts on the future levels of the Official Cash Rate

Is it time the Reserve Bank (RBNZ) stopped giving us specific forecasts of where it expects the Official Cash Rate (OCR) to be in the future?

That might sound like a strange thing to suggest, given it would seem helpful that we currently get quite a detailed picture of where the RBNZ sees rates going. But you know what they say about good intentions...

I was prompted to opine on this subject by reading a commentary by HSBC economist Paul Bloxham questioning the usefulness of the RBNZ's forward guidance. He makes some good points.

It seems to me that the OCR forecasts instead of just being a guide are in themselves becoming a key driver of our retail interest rates. Therefore, far from being helpful, I think the forecasts - by being so specific - could be counter productive. Yes, I get the idea of providing some view of what will happen in the future - but to give it in specific numbers seems too much to me.

I increasingly wonder if, by indicating explicitly where it sees future interest rates heading, the RBNZ is opening the door to adverse moves in actual rates and harmful distortions.

In the grand scheme of things, this may seem like a minor point. But I don't think it is. I think the issuing of these forecasts is becoming an unhealthy focus point.

And I also think as we start to move down from the OCR's recent 5.50% peak, the chances are there for even greater distortions.

The RBNZ would presumably need some convincing to change its mind on this issue.

This is what RBNZ Governor Adrian Orr said on the general subject of forward guidance this week in response to a question at the post-OCR review press conference:

"Central banks that provide forward paths wish they didn’t those that don’t wish they did. There is no known practice. We have had a longstanding practice here of putting our best foot forward out, subject to people understanding the conditionality. When the facts change the decisions change and that’s what we are working through always. That has worked very well for us. I’ve heard central banks who do scenarios wishing they didn’t do scenarios because everybody focuses on that one scenario. So, it’s horses for courses."

Well, okay, fair enough. But I would argue the potential is there for the RBNZ's outlining of an OCR rate track as explicitly as it is currently done to NOT work well in future.

As this is all bit complicated, I'll try to explain my case carefully. First, some context:

At the back of its quarterly Monetary Policy Statements (see page 51) the RBNZ publishes, along with several other economic forecasts, a forecast for the level of the OCR over the course of the next three years. 

As indicated by the above Orr comments, our central bank is not alone in providing such forward guidance. The US Federal Reserve's Federal Open Market Committee (FOMC), for example, has been doing something along these lines since 2012 with its so-called 'dot plot' graphs. But without going into all the detail, the FOMC forward guidance is rather less specific than that provided by the RBNZ.   

It may be of some surprise to you that such explicit OCR forecasts in their current form have appeared in RBNZ MPS documents only since November 2016. Prior to that, and from 1997, the RBNZ had run a forecast of the expected level of the 90-day bank bill rate. This effectively served as a 'proxy' for the OCR, given that you could subtract 20 or 30 basis points from the rate and 'get' an expected OCR level.

So, anyway, between 2016 and early 2020 there wasn't 'much to see here' with the OCR forecasts as inflation was virtually non-existent, so interest rates didn't need to move from very low levels. Then in March 2020 in reaction to the developing pandemic, the RBNZ slashed the OCR to 0.25%, pledged to keep it at that level for at least the next 12 months and subsequently therefore stopped making any forecasts about the OCR till the May 2021 MPS. So it was that in May 2021 the forecasts came back with a hiss and a roar. And an enormous market impact. Those forecasts showed SIX rate hikes over the next three years. Once the market digested that information, mortgage rates started quickly shooting up - before the actual OCR had even moved at all.

Just over two years ago now, I wrote on this subject, and said that we had now developed this thing called the 'Future OCR', and it was this 'Future OCR' - through the RBNZ forecasts - that was driving market pricing of current interest rates (including mortgage rates), rather than the actual OCR. The actual OCR was lagging behind as 'Future OCR' headed for the moon. In effect mortgage rate rises were being based on expectations of where the OCR was going to go, rather than where it was.

Now, there was a certain effectiveness about that as we were on the way up - at least at the start of the OCR hiking cycle in late 2021. The markets were driving up mortgage rates even before the OCR was physically shifted. However, I do wonder if this chasing of the 'Future OCR' led mortgage rates to go higher than they might have needed to be and also if in a strange way this dynamic also led to the actual OCR ending up higher than it might otherwise have done.

Everything goes up

It's difficult to prove a case on this, but the fact is that expectations of the future level of the OCR became quite similar to the dreaded 'inflation expectations', whereby people expect prices will go up, so they put THEIR prices up, hence fueling real inflation. I think we saw a bit of the same behaviour with interest rate pricing. Everybody was pushing everything up - and that might have even fed back into upward pressure on the OCR itself.

The RBNZ is always quick to say that the OCR forecasts are not a prediction, nor do they indicate specific levels the RBNZ wants the OCR to reach. Rather, the forecasts are a kind of mechanical production that comes out of all the various economic variables the RBNZ throws into its forecasts. Imagine it as a kind of: CPI inflation of X%, plus economic growth of Y%, plus unemployment of Z% equals an OCR of XX% equation.

The fact is though, that if you put a specific figure down on a piece of paper it gets taken seriously and so in the short term the markets react to that. If the RBNZ doesn't want us to take those very specific future OCR forecasts as a yardstick to measure current market rates against, then maybe it should just keep those forecasts to itself.

It's fair to say that the OCR forecasts are always 'wrong'. For example, just before the RBNZ slashed the OCR in 2020, the February 2020 MPS forecast an OCR of just under 2% for March 2023. Well, as we know, the actual level of the OCR as at March 2023 was 4.75% and still rising on its way to 5.5% by May 2023. 

However, there's no doubt the OCR forecasts set the tone for the direction in which the OCR travels.

I think the forecasts have become too much the centre of attention. And I say that, perhaps somewhat hypocritically, as someone who immediately went to the back of the August MPS when it was released this week to find out what the new 'OCR track' was - because I knew that' s what people would want to read and also what would be the second most important thing for the economists to digest - after they had seen what the actual OCR number was.

An unwelcome distraction

So, I think the 'Future OCR' has become an unwelcome distraction. More than this, though, I think the forward guidance in its current form has switched from something that is a 'guide' and has become almost a marketing tool. And if it isn't a marketing tool as such now, it certainly has the potential to end up being as such.

After the OCR reached what became the top of the hiking cycle at 5.50% in May 2023 the RBNZ was in the interesting position of probably having to suggest that the OCR would be 5.50% for some time. But the question was then whether the financial markets were going to start second-guessing and knocking down wholesale interest rates, which could then lead to falling mortgage rates - something the RBNZ did not want till it felt inflation was under control.

So, we then started seeing the RBNZ putting into the OCR forecast rate track the possibility of future rate rises. It gets complicated because of how its done, but in the November 2023 MPS the forward OCR track showed a 75% chance of another hike. This was reduced to a 40% chance in the next MPS in February 2024, but then increased again in May 2024 to 60%.

Frankly that's all been very odd. It has had the effect of keeping retail interest rates more elevated than they might have been. But to what extent has the OCR forward track been a 'guide' and to what extent has it actually been driving monetary policy? And is that what we really want?

I see potential problems ahead now that we have reached the top of the hill with the latest interest rate cycle and are starting to move down again.

Prior to the RBNZ's OCR review this week the financial markets were pricing in an OCR of 3.25% by the end of 2025. The RBNZ has now put out a new OCR rate track in its August 2024 MPS (page 51), which shows the OCR dropping to under 4.0% by the end of next year. The financial markets are now pricing in an OCR of just over 3.0% for the end of next year.

Crossing swords

So, even after the RBNZ changed its forward path dramatically, the markets are still undercutting it and see about three or four more cuts than the RBNZ does. And I reckon this might just be the start of it as banks now start to increasingly play chicken with each other in reducing mortgage rates possibly rather quicker than the RBNZ wants. And what if the rates start to fall fast enough that the currently moribund housing market starts to wake up again? We are only ever a heartbeat away from a FOMO (fear of missing out) market in New Zealand. The RBNZ would need that like a hole in the head.

What do I suggest?

I say drop the OCR forecasts. The RBNZ has plenty of weapons at its disposal to keep the market informed without needing to be so arbitrary as putting up future OCR numbers. I think the OCR track has become a major distraction and in an unhelpful way.

The fact is that by putting up numbers of the expected level of the OCR in such an explicit way, the RBNZ is baking in expectations of where interest rates SHOULD go. And I think that can only lead to increased volatility, with potentially some adverse moves in retail interest rates that could be avoided.

What would happen if there is no such specific forward guidance? Well, the RBNZ can of course 'guide' the market in other ways without needing to put up numbers. If the forward OCR guidance were to be removed and the RBNZ then found itself in a situation where it was unhappy with the market's pricing of interest rates, what would it do? Well, it could simply physically move the OCR of course. That way we would once again have interest rates controlled by the actual OCR and not the 'Future OCR'. Wouldn't that be a good idea?

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