By Bernard Hickey
The Reserve Bank of New Zealand has cut the Official Cash Rate by 50 basis points to 2.5% as a pre-emptive move to cushion the economy from the impact of the Christchurch earthquake on February 22.
But the bank has warned that the easing will have to be removed “once the rebuilding phase materializes.”
The Reserve Bank estimated rebuilding costs in Christchurch of NZ$15 billion and forecast a 0.6% fall in GDP in the first quarter of this year because of the earthquake.
The Reserve Bank said its forecasts for the economy were based on limited information and significant assumptions that would be tested by more information in months to come.
“For now, GDP growth is projected to be quite weak through the first half of the year. This will gradually build up to a very large reconstruction programme by 2012 that will last for some years and contribute to a period of relatively strong activity,” Governor Alan Bollard said.
“This will gradually build up to a very large reconstruction programme by 2012 that will last for some years and contribute to a period of relatively strong activity,” he said.
“Future monetary policy adjustments will be guided by emerging economic data. We expect that the current monetary policy accommodation will need to be removed once the rebuilding phase materializes,” Bollard said.
“This will take some time. For now we have acted pre-emptively in reducing the OCR to lessen the economic impact of the earthquake and guard against the risk of this impact becoming especially severe,” he said.
The Reserve Bank revised down its forecast track for the 90 day bill rate, but did not publish its quarterly estimates of where the rate might be.
It forecast an average 90 day bill rate of 3.1% in calendar 2011 and 3.0% in calendar 2012, before rising to 4.2% in 2013 and 4.6% in 2014.
The Reserve Bank’s 90 bill rate forecast is the closest indication of where it thinks the OCR might be, although it has clouded its forecast this time somewhat by not publishing its quarterly forecasts.
Floating mortgage rates tend to be around 3% higher than the 90 day bill rate forecast.
Banks immediately cut their floating mortgage rates from around 6.1% to around 5.6%. See Gareth Vaughan's article here.
Why is the Reserve Bank cutting interest rates when inflation is expected to rise over 5% this year?
Why is it cutting interest rates back to a record low when commodity prices are at record highs and the bank has lifted its own inflation forecasts in its Monetary Policy Statement?
The simple answer is the bank wants to give the economy a confidence boost to ward off an “especially severe downturn”. It described it as an insurance policy against such a downturn.
But there is a strong case that the Reserve Bank should have left the Official Cash Rate on hold at 3% and the bank acknowledges this in its own Monetary Policy Statement.
Academic research has found that natural disasters such as an earthquake or hurricane will trigger inflation in the following years as intense rebuilding work pushes up the cost of materials and services. Higher rents and insurance costs also feed through into inflation.
Here’s what the Reserve Bank itself says (with my emphasis bolded):
“The earthquake will be causing some prices to increase. Most notably, rents – both for residential and commercial premises – are likely to increase over the next few weeks. This effect is likely to be felt outside of Christchurch given the flow of people temporarily leaving the area. In addition the cost of insurance is likely to increase.”
“The earthquake’s more persistent impact however, is the likely boost to inflationary pressure generated by the mobilization of resources required for the rebuilding of Canterbury. Because reconstruction is likely to take many years, this inflation impulse could prove persistent.”
“Given monetary policy’s focus on the medium term trend in inflation, it would therefore be inappropriate, all else equal, for monetary policy to be stimulatory during reconstruction.”
So the Reserve Bank itself is saying the earthquake could trigger a “persistent inflation impulse” through the economy.
So why is it cutting?
Here’s the Reserve Bank’s argument.
“In the near term however, the earthquake is clearly having a negative impact on activity. It is difficult to know how large or how long lasting this impact will be, but there is a risk that the downturn is quite severe. To guard against this risk it is appropriate for monetary policy to become more supportive.
“Lowering the OCR should be regarded as an insurance measure, designed to help offset the negative economic effects of the earthquake until such time as rebuilding – and a recovery in the broader economy – act to draw on the economy’s surplus resources.”
Can it change into reverse quickly?
The Reserve Bank also pointed out that many borrowers are now on floating rates, which gives the Reserve Bank the flexibility to reverse the easing quickly.
This assumes the move to floating from fixed continues, given that still less than 50% of the mortgages in New Zealand are floating. There is a risk of a reversal of that trend if the banks keep their fixed rates below their floating rate, as has been the case for the last week.
Monetary policy is a blunt instrument and a double edged sword at that.
A lot of retirees in Christchurch and elsewhere are about to see their incomes from term deposits slashed.
There is a danger that just as this monetary policy easing is flowing into the economy in earnest in 12 months to 18 months time, the inflation from the rebuilding effort and inflation from higher commodity prices globally hits the economy in a double whammy.
I think the Reserve Bank should have waited for more data on the true impact of the earthquake and put a bit more faith in the resilience of the New Zealand economy.
It has now opened up the risk that a slow growing economy is burdened by inflation and higher unemployment.
Today’s cut may be seen as the day New Zealand invited in stagflation.
BNZ's Stephen Toplis:
The March 2011 RBNZ Monetary Policy Statement revealed a Reserve Bank exclusively focussed on the Christchurch earthquake. Fears that this event might derail New Zealand’s nascent recovery led to the Bank slashing its cash rate by 50 basis points to 2.5%. However, the Bank was very quick to point out that this reduction was an “insurance” or “emergency” cut and would be removed as soon as matters Christchurch settled down.
Moreover, officials were equally speedy to note that the Bank’s view of the world already incorporates a very dim short-term outlook for New Zealand such that very weak near-term data will not increase the odds of a further cut.
As a consequence of today’s reduction, we have shifted the starting point in our own forecast track to 2.5% but have not changed the rest of the track at all. We still believe that the Reserve Bank will be pushing the cash rate higher by late this year/early next and that it will be 4.5% by the end of 2012. Interestingly, this is now very close to the RBNZ’s own published predictions.
The Bank’s 90 day bank bill track implies the cash rate will be 75 basis points higher than where it is now by Q1 2011 rising to around 4.5% by late 2013. It is also worth noting that the Bank’s bill rate track doesn’t drop to a level consistent with a 2.5% cash rate at any stage. This implies that there was significant debate as to whether a 25 point or 50 point cut at this juncture was appropriate. That said, the Bank’s rhetoric suggests that it had already been spooked by macro data coming in softer than anticipated even prior to the earthquake.
We’ve always been in the camp that rate cuts were the wrong instrument for the task at hand and remain of this view. However, we can see why the Bank would go 50 rather than 25 in that if you are to support confidence you need to provide a decent shock not a dabbling at the margin. Moreover, by going 50 the Bank can be more adamant that no further cuts will be forthcoming and hence have greater control over the shape of the yield curve as well as the starting point level. We are a bit concerned that the Bank spent very little time discussing the inflationary impact of the earthquake but chose rather to talk about the real economy effect and the personal costs associated with the disaster.
Fundamentally, we believe that the earthquake has significantly raised the inflationary pressure on the economy as it is as much a supply shock as a demand shock. The Reserve Bank has lowered its potential growth forecast for New Zealand over the next few years but by only a cumulative 0.4%. It may be a little optimistic in this regard.
Perhaps the most frustrating aspect of today’s statement was that the Bank decided not to publish Chapter 5: The Macroeceonomic Outlook nor the quarterly tracks for GDP, CPI, the TWI and bank bill rates, as is usual practice. The Bank has hidden behind the fact that there is so much uncertainty that its forecasts become “meaningless”. It then goes on to say it has made a number of heroic assumptions in formulating its view.
Everyone is in the same boat so we would have thought it helpful if those assumptions had been published. As the data flow is printed over the next few weeks we won’t know whether it met the Bank’s expectations or not. This is not how one runs transparent monetary policy. Indeed, if the real answer is that the confusion is so great that the Bank had no idea what was happening it begs the question as to the efficacy of any rate change decision made.
HSBC's Paul Bloxham
Cutting interest rates in response to a negative supply shock is not the textbook response. While an event like this weakens the economy in the short run, it adds to medium-term growth as the capital stock is rebuilt. In this case there will be substantial addition to GDP as rebuilding occurs in the Canterbury region, with the RBNZ estimating capital stock damage of 8% of the value of nominal GDP.
While the rate cut may boost confidence in the short run, the risk is that rebuilding and broader economic recovery - partly due to strong increases in commodity prices -sees inflation hold persistently above the RBNZ's target zone. A targeted fiscal package would seem to have been a more appropriate response.
The RBNZ has judged that the rebuild will take considerable time and the reduction in demand in the interim - via weakened confidence and disruption - is sufficient that demand will not run ahead of supply and put upward pressure on inflation over the forecast horizon.
The RBNZ's inflation outlook is largely unchanged from that presented in the last official statement. In our view there are a number of considerable upside risks to inflation. These include that global inflation is building, oil prices have risen, other commodity prices have risen, and a large automatic fiscal response to the quake, via the Earthquake Commission, will boost the economy over coming quarters.
The OCR is now back at emergency low levels of 2.5%. The focus of discussion will now turn to how soon before the RBNZ will need to begin to reverse this decision and lift rates. This uncertainty may indeed have the effect of dampening confidence.
ANZ's Khoon Goh:
Policy looks set to be on hold for most of 2011. The RBNZ’s projections flag a succession of 25bp hikes from early 2012 – a faster pace of tightening than expressed 3 months ago, but with a similar endpoint. We expect a marginally earlier unwind of policy support relative to the RBNZ.
Key differentiating judgments here are that inflation pressures in 2011 are more pronounced than the RBNZ’s projection, and the current earthquake rebuilding response will be quicker than the September experience. Despite more cautious behaviour expected on behalf of consumers, financial conditions are now so supportive that the New Zealand economy has the potential to turn very sharply in late 2011. This effect is broader than and in addition to the pending reconstruction-related boost.
On the inflation front, our view is less benign than the RBNZ’s projections. We believe there are clear upside risks to the RBNZ’s inflation forecasts in the near term, stemming from higher energy prices. Indeed, when we work out the RBNZ’s implied quarterly CPI profile for this year, we get 0.7 percent for Q1, 1.1 percent for Q2, 0.4 percent for Q3 and 0.1 percent for Q4.
Lower numbers in the second half of the year are critical: the RBNZ needs low figures to see the headline CPI head back into the target band (and when the GST-induced CPI surge in December 2010 falls out of the calculation). Such quarterly outturns, in the absence of a sharp correction in commodity prices (which to be fair is something we wonder about if policymakers across the G7 start to unwind excess liquidity), look a stretch.
To be fair, the RBNZ finalised their forecasts before the 13c/ltr hike in petrol prices. But even excluding that, the Bank’s medium-term inflation forecasts, which settle around 2.2 percent, look far too light given the known upside pressures to prices that are looming. The RBNZ noted that there will be temporary increases in rents, and that insurance premiums will rise nationwide as a result of the earthquake. In addition, construction-related costs will also rise, given the size of the rebuild. Throw on top of that higher energy and food prices, and we easily see medium-term inflation settling towards the top of the RBNZ’s target band rather than closer to the mid-point.
We see policy as now on hold, and the RBNZ will be in data assessment mode. We have pencilled in the first rate hike for December 2011, given our view that inflation will prove less benign than the RBNZ has projected, and that the economy has the potential to turn more sharply in the latter part of 2011. Indeed, a combination of the Rugby World Cup activity, the ramping up in reconstruction work and the diffusion of a massive terms of trade boost looks set to boost economic activity late in the year.
ASB's Nick Tuffley:
It is unlikely the RBNZ will cut further in the short term. The timing of future OCR increases will be closely influenced by the timing of Christchurch reconstruction along with signs of broader economic recovery: we judge the RBNZ will be on hold until March 2012. The decision to cut by 50bp will give the economy some much-needed support in the short term.
It will also settle down interest rate markets: there will be far less second-guessing about any/further OCR hikes as a run of weak data gets released over the next 3-4 months. The RBNZ made it clear that this is likely to be it. Inevitably, markets will turn to anticipating the eventual lift back up in interest rates. Our view is the OCR will start to lift in March but go up at each and every meeting subsequently, to an eventual peak of 4.5%. That is a slightly later, but less gradual, start than our previous view. The risk is, nonetheless, that the start could be slightly sooner.
Timing will be influenced in particular by when the reconstruction activity in Christchurch starts to spool up and brings back the focus on the resultant and persistent inflation pressures. A second influence will be how long the economy appears to need support in the short term. Longer term, markets are still – in our view – underpricing the eventual peak in the OCR – the risk is it ends ups higher than the sub-4% currently priced in.
The earthquake itself will have inflationary effects, not just in Christchurch. The RBNZ will look through the short-term impacts, but any persistent (multi-year) pressures resulting from reconstruction will be leaned against. This period after the OCR release could well mark the low for the NZD vs. the AUD. For exporters, hedging around current levels would lock in an exchange rate that is incredibly competitive, and one that now appears to have more upside than downside risk over the next year.
Westpac's Brendan O'Donovan:
The RBNZ emphasised that today's rate cut was not just temporary, but most likely a one-off. The economy clearly softened through 2010 - the MPS did not provide detailed quarterly forecasts, but hinted that Q4 GDP was estimated to be around flat, following Q3's 0.2% contraction. But high commodity prices are set to provide a major boost to export income, and there was a growing body of evidence that domestic activity had picked up in the weeks before the quake struck.
So while it's perhaps a moot point, it seems that were it not for the earthquake, it's unlikely that a rate cut would have been considered. What's more, softer data in the next few months will not necessarily scare the RBNZ into further cuts - with today's move it has already braced itself for some softer confidence and activity data in the near term.
With so much focus on the immediate impact of the earthquake, there is a risk that the RBNZ's inflation message gets lost in the mix - in fact, inflation was not mentioned in the media release at all. (A word count of the MPS finds that 'earthquake' outnumbers 'inflation' by about 2:1, which seems reasonable in the circumstances.) And it is worth noting that the faster tightening profile for 2012 does not completely offset the inflationary effects of easier policy today and the increased pressure on resources as the rebuild begins. Beyond the GST-induced spike in annual inflation this year, the RBNZ now expects inflation to peak at 2.5% in 2013, compared to a 2.3% peak in its December projections (Figure 3).
We suspect that inflation could reach higher than this, given the global emergence of higher inflation, soaring fuel prices, and the as-yet-unknown capacity of the building industry to meet the demands of the reconstruction effort. But by the standard of its own projections, it would be hard to accuse the RBNZ of abdicating its inflation-targeting duties in the face of a crisis. A 2.5% peak is well within the bounds of the Policy Targets Agreement, which requires an average of 1-3% over the medium term. Obviously, it leaves less room to absorb any upside surprises on inflation, but the RBNZ has already expressed a willingness to lift interest rates quickly once it becomes apparent that inflation pressures are returning.
JP Morgan's Helen Kevans:
We believed that the OCR was the wrong tool to use in response to the earth quake, but had acknowledged the decision was finely balanced, and that if a rate cut was delivered, it would have to be a 50bp move for policy to gain any traction. The RBNZ delivered the 50bp move, but made clear that the decision required many important assumptions “based on quite limited information.” The RBNZ acknowledged, though, that even before the February earthquake, the economy had underperformed, mainly owing to efforts by households to reduce debt. While there had been some signs that the economy was beginning to recover early in 2011, these were more than offset by the Christchurch earthquake.Our view is that the RBNZ will stay on the sidelines for an extended period while officials assess the impact of the earthquake on the economy. The statement made clear today that future policy adjustments would “be guided by emerging economic data” but that the policy accommodation in place would not be removed until the rebuilding phase materialized. This will take some time.
The RBNZ acknowledge there likely would be a boost to inflation pressure as a result of the earthquake. The concern for the Bank would be the possibility that these price rises could lead to second round effects. Should higher prices start to flow through into higher inflation expectations the RBNZ would be forced to remove the current stimulus sooner than we now predict. Indeed, with the exchange rate falling and global inflation pressures rising, New Zealand could see higher domestic inflation. Now, though, with underlying inflation weak, price expectations low, and firms lack pricing power, there is little imperative to lift the OCR back toward neutral.
Interest group reaction:
“We welcome Dr Bollard’s announcement of a 0.5 percent cut to the OCR. The damage and dislocation of the earthquake as well as the slump in business and consumer confidence has made the cut inevitable,” says Don Nicolson, Federated Farmers president.
“While inflationary pressures are building they are largely either imported, such as petrol prices, or from government imposed costs such as local authority rates, excise tax increases, the ETS, and ACC levies.
“However, we are concerned that cost pressures could easily spread through the wider economy and we will be urging the Reserve Bank to ensure it does not let inflation get out of control. Its now more important than ever that government acts prudently and does not increase spending on non-earthquake related projects, or impose any increased fees and charges. This will only increase inflation and make the Reserve Bank’s job harder.
“This OCR cut should offer a respite to business and the exporting community as a whole. We’re sure our government will lead by example and take a serious look at its books,” Mr Nicolson concluded.
(Added updated video, reaction from JP Morgan's Helen Kevans, ASB's Nick Tuffley, BNZ's Stephen Toplis, HSBC's Paul Bloxham, Westpac's Brendan O'Donovan, ANZ's Khoon Goh, and Fed Farmers' Don Nicolson)