RBNZ holds Official Cash Rate at 2.5% as expected; Bollard hints at easing unless NZ dollar falls (Update 7)

The Reserve Bank of New Zealand has announced it has held the Official Cash Rate (OCR) at a record low of 2.5%, in line with most economists' forecasts. (Update 7 with Westpac economist Brendan O'Donovan saying the OCR is unlikely to be cut further and that hikes are likely from the third quarter of 2010) However, Reserve Bank Governor Alan Bollard has kept the bias towards a further easing of the OCR below 2.5%, given any recovery is uncertain and patch. He also warned that the high New Zealand dollar needed to fall or he would have to reassess settings, hinting at further rate cuts. "The forecast recovery is based on a further easing in financial conditions. If this easing does not occur, the forecast recovery could be put at risk. In these circumstances we would reassess policy settings," Bollard said in a statement. Bollard reiterated that he expected to keep the OCR at or below 2.5% until late 2010.

"We consider it appropriate to continue to provide substantial monetary policy stimulus to the economy. The OCR could still move modestly lower over the coming quarters. We continue to expect to keep the OCR at or below the current level through until the latter part of 2010," he said. Mortgage rates have been steady in the last two months after the Reserve Bank signaled it was likely to keep the OCR at or below 2.5% until late next year. However, term deposit rates for up to one year and for more than one year have been edging up since March as banks compete hard for term deposits in an environment where funding on wholesale foreign markets is harder to get and more expensive. ASB economist Nick Tuffley said he thought the NZ dollar would remain strong over the next year, and that ASB still forecast a 25 bps cut in the OCR in both September and October, to bring it down to 2%.

The RBNZ has again reiterated that it is likely to keep the OCR on hold for an extended period, and beefed up its easing bias compared to the June Monetary Policy Statement. While rays of sunshine are appearing around the globe, for NZ there are still dark clouds hanging over its export sector. NZ did not feel the abruptness of the industrial slump that afflicted many countries, but instead the impact of a weaker global demand will linger for some time, particularly in the dairy and tourism industries. The RBNZ noted its forecast recovery is based on a further easing of monetary conditions, notably the NZD. We continue to expect the NZ dollar to be strong over the next year, which does reinforce the prospect of the RBNZ having to cut the OCR further. We retain our view that the RBNZ will cut the OCR by 25bp in both September and October to try and engineer some easing in monetary conditions "“ a view obviously contingent on the NZD and wholesale rates remaining elevated.

Tuffley also noted that swap rates were down at 9:30 this morning from last night's close, although the 90 day bank bill rate was unchanged.

In the interest rate market we observed a drop in rates, with rates down 5-10 basis points on yesterday's close. The RBNZ has the door for further cuts remaining open "“ the market isn't pricing this in yet, but the cautious statement has taken some of the enthusiasm for near-term hikes out of the market.

JP Morgan economist Helen Kevans noted that the RBNZ's statement did not mention many positives, unlike the previous one, and despite a general lift in positive data lately.

There was no mention, for example, of signs of stabilization offshore or "upside opportunities for activity" as there was in the statement accompanying the last OCR announcement six weeks ago. Back then, the RBNZ acknowledged "a potential rebound in household spending and residential investment as a result of the rise in net immigration and the pick-up in the housing market". We were surprised by the absence of such comments today as, in recent weeks, the data flow generally has printed on the upside of expectations - house prices have risen, confidence (particularly business confidence) has improved, and net migration ventured to a two year high in June. So, as it appears, the RBNZ is reluctant to get excited about these recent, positive developments. Clearly, the central bank is becoming more concerned that consumers, amid signs that the prolonged downturn in the economy has bottomed, may revert to their old "˜borrow to spend' habits. Recent RBNZ comments have highlighted the need for a shift away from debt-driven consumption as a key driver of growth. This, though, is a key argument for interest rates not to go any lower.

Westpac Chief Economist Brendan O'Donovan said the Reserve Bank was likely to focus on the domestic economy rather than the economy when push came to shove. The currency was not too over-valued, he argued.

If the market is overestimating the strength of the recovery, then the NZD is likely to fall of its own accord; and if the market is correctly anticipating the recovery then a stronger NZD won't be enough to cancel it out. Nor is it obvious that the NZD is particularly stretched at current levels. The currency is around its long-run average on the trade-weighted index; it's slightly above average against the structurally weak US dollar and below average against the Australian dollar. While prices for New Zealand's 'soft' commodity exports haven't matched the recent rebound in 'hard' commodities, they are still around their long-term trend in NZD terms - an impressive performance, considering that they have generally fallen below trend during previous, milder global slowdowns (Figure 1). So while the threat of further rate cuts can't be dismissed completely, we think the RBNZ will ultimately be guided by the outlook for domestic demand, the area over which it has the most influence. And if domestic conditions continue to improve at their recent pace, the RBNZ should be able to resist the temptation to deliver another short-term hit of monetary stimulus. As Dr Bollard's speech noted: "Sustainable recovery, with rebalancing in demand and the economy's productive base, is mostly a microeconomic matter." A greater contribution to growth from the export sector would be nice to have, but it's not essential for monetary policy. The market responded to the more downbeat than expected tone to the statement, with two-year swap rates down by 14 basis points and NZD/USD dropping by 60pts to 0.6510 on the release. We expect these impacts to be temporary. We remain of the view that the RBNZ won't cut rates further in this cycle, and that rate hikes will commence in the third quarter of 2010. However, the recent mixed signals from the RBNZ make it harder to predict how long they will persist with their easing bias.

Here is the full statement from the Reserve Bank below.

The Official Cash Rate (OCR) will remain unchanged at 2.50 percent. Reserve Bank Governor Alan Bollard said: "Despite signs of a leveling off in economic activity, the economy remains weak. We continue to expect to see a patchy recovery get underway toward the end of the year, but it will be some time before growth returns to healthy levels. "The outlook remains highly uncertain. New Zealand's merchandise exports are heavily weighted to soft commodities. As a result, New Zealand has not benefited to any significant extent from the rebound that has occurred recently in global hard commodity prices. "Overall economic growth is evolving broadly in line with our forecasts in the June Monetary Policy Statement as the low OCR and stimulatory fiscal policy take effect. However, looking forward the level of the New Zealand dollar and wholesale interest rates are higher than assumed in our forecasts. The level of the dollar in particular, is not helping the sustainability of future growth, and brings with it additional economic risks. "The forecast recovery is based on a further easing in financial conditions. If this easing does not occur, the forecast recovery could be put at risk. In these circumstances we would reassess policy settings. "Annual CPI inflation is currently well within the target band and it is expected to track comfortably within it over the medium-term. "We consider it appropriate to continue to provide substantial monetary policy stimulus to the economy. The OCR could still move modestly lower over the coming quarters. We continue to expect to keep the OCR at or below the current level through until the latter part of 2010."

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