By Bernard Hickey
The Reserve Bank of New Zealand (RBNZ) has held its Official Cash Rate (OCR) at 2.5%, as expected.
Releasing its December Quarter Monetary Policy Statement, the Reserve Bank said the global economic outlook had deteriorated because of the European financial crisis, which meant economic growth and inflationary pressures remained subdued in New Zealand.
But the bank again reduced its forecast track for the 90 day bill rate by around 30 basis points over the next two years, suggesting it now sees the OCR peaking at around 3.75%, rather than the 4% peak it forecast in its September Monetary Policy statement.
Reserve Bank Governor Alan Bollard said global conditions had deteriorated, as foreshadowed in the Bank’s September outlook.
“Continuing difficulties related to sovereign and bank debt in a growing number of European economies have resulted in high levels of volatility in financial markets,” Bollard said, adding there had also been a softening of activity in the key Asia Pacific region,.
“Global developments are having some negative impact on New Zealand, though to date it has been limited. Business confidence has declined and investment spending is likely to remain weak for some time,” he said.
“In addition, tightness in international markets means funding costs for New Zealand banks will increase to some degree over the coming year.”
The Reserve Bank said this may put some upward pressure on retail interest rates relative to the OCR. See my comment piece on bank profits here.
“Monetary policy will need to take account of such pressures,” the bank said in its statement, adding that banks were likely to have to fund any growth in lending in the coming year or two from local term deposits. See Alex Tarrant's article on banks hunting for term deposits.
Bollard said there had been a material increase in the risks around the outlook and the Reserve Bank took the unusual step of sketching out an alternative scenario for an even weaker outlook with lower growth and inflation pressures.
In this alternative scenario it saw 90 day bill rates (and therefore potentially the OCR) flat until the end of 2012.
The bank said financial markets were currently pricing in a flat 90 day bill rate for an extended period, which was consistent with this alternative scenario.
The New Zealand dollar firmed slightly by mid-morning, but was broadly unchanged given the RBNZ's comments on an alternative scenario being in line with market expectations.
Bollard summarized the outlook thus:
“Given the current unusual degree of uncertainty around global conditions and the moderate pace of domestic demand, it remains prudent for now to keep the OCR on hold at 2.5 percent.”
BNZ's Head of Research Stephen Toplis said the Reserve Bank still appeared inclined to tightening, albeit at a later date. BNZ has shifted its expected first hike in the OCR out to September 2012.
The latest MPS projects the NZ economy won’t run into any capacity (core-inflation) problems until well into 2013. We believe it will be sooner than this, barring a major international downturn.
This is why we have the OCR peaking at a higher level than does the Reserve Bank. We are looking for 4.25% (previously 4.50%) by September 2013. Today’s MPS implies 3.75%. Not a great big difference, but meaningful enough to get across our story, and especially so in an environment where the markets have been disinclined to price in any hikes, while being keen to price near-term cuts. The main change we’ve made is simply to delay the start of the rate hike cycle we see, to September 2012. This is no later than the MPS infers
For the meantime, however, the international backdrop will no doubt get all the attention. That’s understandable. But we’d also state, don’t lose sight of the path of the NZ economy through all of this. It may yet surprise with its robustness, and inflation.
ANZ Chief Economist Cameron Bagrie said the statement's tone was more downbeat and he was still pencilling in the RBNZ remaining on hold until December next year
Compared to the September MPS (and the October OCR Review), the tone was more downbeat, with a more negative outlook for the global economy and higher assumed bank funding costs. This was not surprising given that the global economic outlook had deteriorated since the RBNZ’s last set of forecasts, and European sovereign debt concerns are still unresolved. In explaining its decision to leave the OCR on hold at 2.5 percent, the RBNZ cited “the current unusual degree of uncertainty around global conditions and the moderate pace of domestic demand.” This is very similar in spirit to their October Review.
However, the RBNZ made no reference to the OCR moving up this time, a clear change from prior communication. This means that the RBNZ has now shifted into neutral gear. However, this does not mean that the Bank is signalling any intention to ease. Far from it. True, the RBNZ’s 90-day projection has been revised down considerably, with a later and less steep increase, peaking at 4.0 percent compared to 4.3 percent in the September MPS.
But it still shows the 90-day interest rate moving up, eventually. Technically, the RBNZ's 90-day interest rate projections look to have the OCR moving up from around the middle of 2012. However, this looks nothing more than the passive workings of their economic model, and is based on a pretty benign central view of global developments. Sifting the tea leaves, the spirit of the RBNZ's view is simple: the odds are that the next movement is up, but not for a very long time.
Westpac Chief Economist Dominick Stephens said the RBNZ had softened its stance to "hikes from mid-2012"
It is now signalling a gentle series of OCR hikes beginning in June 2011 and culminating in a peak 90-day rate of 4.0%. That compares to last September when the RBNZ signalled a steep series of hikes beginning in early-2011 and peaking at a 90-day rate of 4.3%.
The details were slightly more hawkish than we expected. As expected, the RBNZ continues to believe that the domestic economy will require higher interest rates because "over time, repairs and reconstruction in Canterbury will ... provide a significant boost to demand for an extended period". Also as expected, the start date for hikes has been pushed out "for now" due to "unusual uncertainty around global conditions."
But the RBNZ stared down market pricing for possible OCR cuts in no uncertain terms. The MPS featured an alternate scenario in which the world economy contracts in similar fashion to the 2008/09 global recession. The alternative 90-day rate forecast was flat. In other words, the RBNZ is saying that even if in a much worse world situation, they'd aim for unchanged interest rates rather than cutting the OCR.
The exchange rate and interest rates dropped at first, which we felt was a counter-intuitive given that the RBNZ had responded to the market's question about cuts with an unambiguous "no." Pricing later rebounded, leaving rates and the exchange rate broadly unchanged. Market pricing for possible OCR cuts reflects a tail-risk of a dire outcome in Europe. So until the European situation is resolved one way or another, the gap between market pricing and RBNZ projections is likely to remain.
Our own view is that the next move will be a 25bp hike in September. We are just a bit more pessimistic about the prospects for Asian and European economic growth than the central bank, but the difference of opinion is minor.
Where our view does differ is that we think the peak in the tightening cycle will need to be much higher than 4%. We’ve alluded to this view many times before. To recap our argument, we don’t believe that higher bank funding costs can forever be offset with a lower OCR. The ‘new normal’ in global credit markets means that the world is less willing to lend to New Zealand at any given interest rate. With less funding coming from overseas, more of the gap would need to be made up from local sources – and that would require higher domestic interest rates to balance savings and loans. To say that this can be completely offset through a lower OCR is effectively saying that we can dictate to international lenders what return they will receive. There are many parts of Europe that are currently demonstrating otherwise.
ASB Chief Economist Nick Tuffley said the Reserve Bank had revised its forecasts for global growth below consensus expectations.
The RBNZ is now explicitly assuming an increase in bank funding costs over the coming year as a result of the financial difficulties in Europe. However, the assumption of an added 30 basis point increase in funding costs highlights that the RBNZ continues to expect the impact of the Eurozone Sovereign debt crisis on NZ will be relatively mild.
There were few surprises in the Statement. The key message is the RBNZ will remain on hold for a considerable time, until offshore risks (both financial and economic) have receded substantially. We recently changed our expectation of when the RBNZ is likely to first raise the OCR to December 2012, and still view that as the most likely timing in the wake of the MPS – though in the current risk environment a broad span of timing is possible.
The RBNZ has a more substantial EU downturn factored in than the latest Consensus forecasts imply, so is in effect already accounting for further near-term downgrades to the lagging Consensus view.
The RBNZ’s new 90-day interest track now implies a first move in 2012 Q3, relative to 2012 Q1 in the September MPS. The forecast 90-day peak of 4% remains consistent with a low OCR peak, and we are comfortable with our view that the OCR will eventually peak at 4% late in 2013.
Rate cuts still appear very unlikely, and in our view would only be a prospect under extreme circumstances. The RBNZ’s alternative scenario, using recent market interest rate pricing as a starting point, implies that even a fairly substantial deterioration of the global outlook would be more likely to mean rates being on hold for a much longer period. There was no material market reaction.
HSBC Chief Economist for Australia and New Zealand Paul Bloxham said the tone of the RBNZ statement was more dovish than the previous one and HSBC had pushed back its forecast for the first rate hike to the third quarter of 2012.
Rates in New Zealand are already at historically low levels, so despite global risks, cuts were not a consideration today. Indeed, we see it as unlikely that the RBNZ would consider cutting rates further, and we still expect that the next move is up. But with global risks prominent and the impact of European developments impacting growth in Asia, we believe that the Reserve Bank of New Zealand will be on hold for longer than previously expected.
Like a boxer trying to pick themselves up off the canvas, the RBNZ has been struggling to lift rates from what they were referring to as ‘emergency levels’ put in place after the Canterbury earthquake in February. The RBNZ now has dropped the phrasing of ‘emergency levels’, implying that these low rates may be held for some time yet. Indeed, it may be the case that we have seamlessly moved from one emergency to the next. Where we are may be the ‘new normal’, at least for a while.
Concerns about the outlook stem from both weaker growth forecasts for New Zealand’s trading partners and the impact that the increased cost of offshore bank funding will have on local retail interest rates. RBNZ estimates suggest that the cost of funding has already risen by about 40bps in the past few months. They also clearly note that ‘monetary policy will need to take account of these pressures’.
For policy, the RBNZ is still forecasting an upward slope in 90-day bank bill rates, rising to 3.6% by end-2012, implying that they still expect the next move is up. A country with a large net foreign funding requirement, such as New Zealand, would be hard-pressed to lower interest rates too much further, as it may start to have deleterious effects on its ability to fund itself. We believe this will be a key factor that keeps the RBNZ from considering further cuts.
(Updated with details, economists reactions from Westpac's Dominick Stephens, ASB's Nick Tuffley, BNZ's Stephen Toplis and HSBC's Paul Bloxham updated video)