Opinion: OCR cut shows RBNZ concerned about economic outlook

By ASB Chief Economist Nick Tuffley and ASB Economist Jane Turner Front loaded The bold move to cut 150bp and accompanying Monetary Policy Statement suggest that the RBNZ are very concerned about the economic outlook and continue to see risks firmly skewed to the downside. This was highlighted by the fact that the decision to cut 150bp was made almost 2 weeks ago, with these concerns sufficient to push the RBNZ to further front load rate cuts to bring hasten the arrival of relatively low borrowing costs. In Thursday's press statement the RBNZ noted that "ongoing financial market turmoil and the marked deterioration in the outlook for global growth have played a large role in shaping today's decision." Continued deterioration in the global situation was concerning the RBNZ back then and those concerns have intensified. Though the RBNZ has again attempted to keep a lid on expectations of where the OCR is headed, events are still going to play a part. Globally news is likely to get worse, reinforcing the downside risks to global growth the RBNZ has noted. Further downward revisions to the RBNZ's growth and medium-term inflation outlook are a near certainty. The MPS forecasts imply a terminal OCR of 4.5%, according to the RBNZ "“ forecasts that will be knocked lower. We see a 3.5% - 4% finish for the OCR as very conceivable. We expect the RBNZ to cut the OCR by as much as 100bp in January and a "˜fine-tuning' 50bp in March, finishing at 3.5%. That would put interest rates at what would in the past be considered an extraordinary stimulatory level, but these are extraordinary times. There is a risk that view looks a little extreme in the here and now, but the lesson of the past few months is that circumstances can change within a very short time period. Overview The RBNZ delivered a 150 basis point cut, bringing the OCR to 5.0%. The market had moved to expect the 150bp cut so today's move was not a large surprise. The deterioration in the global economic outlook and continued disruption in the global credit markets were key factors behind further front loading of interest rate cuts. The global environment has become materially worse since the decision and forecasts were finalised, implying there is already downside risk to the RBNZ's outlook. In addition to the global environment, the domestic outlook has also weakened materially, with a much lower terms of trade outlook and downside risks to employment and investment assumptions. Weaker growth outlook, falling commodity prices and easing inflation expectations have increased the RBNZ's confidence that inflation pressures will continue to abate. Growth lower & risks to downside The RBNZ sees the business environment having deteriorated significantly, referring to firms cutting back investment, cutting back on employees hours worked and, increasingly, reducing staff numbers. Other negative factors to the growth outlook weighing on the RBNZ were:

• Increased financial market dysfunction and global credit markets remaining seized up.
• Weaker trading partner growth, with growth projected to reach "multi-decade lows in 2009" as many of our trading partners are expected to go into recession and Asia expected to slow materially.
• Considerably weaker Terms of Trade - with the fall in export prices expected to more than outweighing the decline in oil prices. The decline in the Terms of Trade is essentially a fall in incomes and will be removing a large amount of support from the NZ economy.
• Sizable declines in employment and investment are expected and acknowledgement that even sharper adjustments are possible.
• Concerns the economy will not make the recovery expected by 2010, seeing considerable uncertainty given the nature and severity of global forces.

Effective mortgage rate not low enough? The effective mortgage rates remains a focus of the RBNZ, noting that it is expected to fall, albeit relatively slowly due to the predominance of fixed mortgage rates and its impact on consumption will be muted by households increased desire to save. Inflation pressures abate As a result of the weaker growth outlook and falling commodity prices, the near term inflation forecasts have also been revised down sharply. In addition, the fall in inflation expectations has made the RBNZ more confident of medium-term inflation pressures abating, with inflation excluding the Emissions Trading Scheme projected to hover just below 2.5%. Growth risks to downside Even though the RBNZ has become noticeably more bearish, the risks to its forecasts still remain to the downside. Indeed we were surprised they were not revised down further given the focus to the downside risks. The RBNZ sees the economy pulling out of recession by the end of 2008, however we see a strong possibility that the recession will continue through the first half of 2009. Key to the outlook over the next six months or more is the extent of the disruption to global credit markets, global growth and trade. Even the RBNZ acknowledges the global downturn could be worse and more protracted than its forecasts factor in. In this environment is prudent to be focusing on the downside. However it is surprising there does seem to be considerably less discussion around the positive stimulus on the horizon in the form of lower interest rates, looser fiscal spending, lower petrol prices and the lower NZ dollar that has been paid in previous statements. Market Reaction The move was in line with market thinking, which had moved close to fully pricing in 150bp of cuts prior to the meeting. The reaction in the interest rate market likely reflects traders taking profits from trades based on the yield curve steepening. The one year swap rate has risen from 4.75 prior to the meeting to 4.82 now, and the five year rate has moved from 5.28 to 5.3. The RBNZ's 90 day bank bill track is indicative of a terminal cash rate around 4.5% around the middle of next year. The OIS market continues to expect more aggressive action, with 50bp cut fully priced in for the next meeting, and a terminal cash rate of 3.75% nearly priced for mid 2009. We see downside risks to the RBNZ's growth outlook, and cash rate outlook, as well as the potential for the OIS market to price in a bigger cut in January, and a lower end point for the OCR (3.5%). The NZD has been relatively quiet, and lifted from 52.80 prior to the meeting to 53.40 at the time of writing. Implications: 150 on Thursday, another 150 next year? We expect the RBNZ to cut the OCR further in early 2009, though the magnitude of the cuts will be smaller. One key aspect to today's decision was going to be whether the RBNZ felt galloping market expectations were pushing it towards a 150bp cut or whether it had sufficient concern about the economic outlook that a large cut was easily justified. Comments indicate it was the latter: the decision to cut 150bp was made nearly 2 weeks ago to hasten the arrival of relatively low interest rates. Continued deterioration in the global situation was concerning the RBNZ back then and those concerns have intensified. Though the RBNZ has again attempted to keep a lid on expectations of where the OCR is headed, events are still going to play a part. Globally news is likely to get worse, reinforcing the downside risks to global growth the RBNZ has noted. Further downward revisions to the RBNZ's growth and medium-term inflation outlook are a near certainty. The MPS forecasts imply a terminal OCR of 4.5%, according to the RBNZ "“ forecasts that will be knocked lower. We see a 3.5% - 4% finish for the OCR as very conceivable. We expect the RBNZ to cut the OCR by as much as 100bp in January and a "˜fine-tuning' 50bp in March, finishing at 3.5%. That would put interest rates at what would in the past be considered an extraordinary stimulatory level, but these are extraordinary times. There is a risk that view looks a little extreme in the here and now, but the lesson of the past few months is that circumstances can change within a very short time period. * ASB's weekly Economic Notes are available here.