By Bernard Hickey
The Reserve Bank has held the Official Cash Rate unchanged at 2.5% for a record 21st consecutive decision, but it has held out the prospect that the persistently high New Zealand dollar gave the bank the flexibility to delay or reduce any rate hikes it said were likely in 2014. The bank last changed the OCR in March 2011.
The bank repeated its warnings about house price inflation and the exchange rate being too high, but it also noted stronger economic growth than in its September quarter Monetary Policy Statement.
It said it expected to leave the OCR on hold through the rest of 2013 and repeated that rate hikes were likely in 2014.
But this time it pointed out the high New Zealand dollar was pressing down on inflation and gave it some room to delay or reduce the size of those hikes in 2014.
"Sustained strength in the exchange rate that leads to lower inflationary pressure would provide the Bank with greater flexibility as to the timing and magnitude of future increases in the OCR," Governor Graeme Wheeler said in an eight paragraph statement.
Westpac and BNZ economists changed their forecasts for the first OCR hike after the statement. Westpac shifted its forecast to an April hike from a March hike, while BNZ shifted its forecast to June from March.
This is the 'in-between' OCR decision with just a statement, rather than the full quarterly Monetary Policy Statement (MPS) released with fresh forecasts, a full news conference and an appearance by the Governor before Parliament's Finance and Expenditure Select Committee.
Before this decision, economists had mostly been forecasting the bank would start increasing the OCR from March next year and increase it by around 1 to 1.5% over the following year. However, some (ASB, Westpac and ANZ) had suggested earlier this week the Reserve Bank could signal its high LVR speed limit and the high New Zealand dollar could allow a later start and lower rate hikes.
The bank did not reforecast interest rates in the statement (it only does that with its quarterly MPS). In September it forecast it would start raising the OCR from the March quarter of next year and lift it around 2% by early 2016. Today's statement suggests the start may be later and the rise could be less if the New Zealand dollar stays strong or gets even stronger.
Here's my reading of the differences between the September MPS policy assessment and the Reserve Bank's statement today.
Parsing the statements
October 31 - The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 2.5 percent.
Reserve Bank Governor Graeme Wheeler said: “The recovery in the United States and other major advanced economies remains patchy. Nevertheless, world prices for New Zealand’s export commodities are very high.
“Global long-term interest rates are still very low, but have been volatile recently. This volatility has largely been due to uncertainty as to when the Federal Reserve will exit from quantitative easing."
September MPS – The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 2.5 percent.
The global outlook remains mixed. GDP growth in Australia and China has slowed and some emerging market currencies have come under considerable downward pressure. At the same time, the major developed economies continue to recover and New Zealand's export commodity prices remain very high.
Although long term interest rates have risen globally in recent months, largely due to uncertainty around the timing of the Federal Reserve's exit from quantitative easing, global financial conditions overall continue to be very accommodating.
The difference: Not much difference here, unless you want to have a debate about the differences in the meanings of "patchy" and "mixed".
October 31 - “The New Zealand economy is estimated to have grown by more than 3 percent in the year to September. Household spending is rising, and reconstruction in Canterbury is being reinforced by a broader rise in construction in Auckland and across the country more generally. This will support economic activity and start to ease the housing shortage.
“In the meantime high house price inflation persists, especially in Auckland. As has been noted for some time, the Reserve Bank does not want continued high house price inflation to compromise financial or price stability. Recently introduced restrictions on high loan-to-value mortgage lending are expected to help slow house price inflation and the Bank will continue to monitor the situation closely.
September MPS – In New Zealand, GDP is estimated to have increased 3% in the year to the September quarter. Consumption is rising and reconstruction in Canterbury will be reinforced by a broader national recovery in construction activity, particularly in Auckland. This will support aggregate activity and start to ease the housing shortage.
In the meantime, rapid house price inflation persists in Auckland and Canterbury. As has been noted for some time, the Reserve Bank does not want to see financial or price stability compromised by continued high house price inflation. Restrictions on high loan to value residential mortgage lending, which will come into effect next month, are expected to help slow the national housing market.
The difference: The Reserve has pointed to growth being more than 3% this time, rather than just 3% last time. It also commented again on its high LVR speed limit, but didn't specifically link it to the monetary policy outlook, which some economists thought it might do this time around.
October 31: “The exchange rate remains high and is a headwind to the traded goods sector. Sustained strength in the exchange rate that leads to lower inflationary pressure would provide the Bank with greater flexibility as to the timing and magnitude of future increases in the OCR. Fiscal consolidation is also expected to continue weighing on demand over the next few years.
September MPS: Despite having fallen on a trade weighted basis since May 2013, the exchange rate remains high. A lower rate would reduce headwinds for the tradeable sector and support export industries. Fiscal consolidation will weigh on aggregate demand over the projection horizon.
The difference: This is where the 'news' in today's OCR announcement sits. The bank's comment about the high New Zealand dollar giving the bank flexibility on the timing and size of any OCR hikes has given the bank room to delay OCR hikes from the March quarter, which was when the market was expecting rates to be hiked before today's OCR. This essentially means the Reserve Bank sees deflation in imported goods prices helping it keep inflation under control and allowing it to keep rates low for longer.
October 31: “Annual CPI inflation increased to 1.4 percent in the September quarter. As domestic demand pressure picks up, headline inflation is likely to rise towards the 2 percent target midpoint. The Bank is aiming to keep inflation and inflation expectations close to 2 percent over the medium term.
“Although we expect to keep the OCR unchanged in 2013, OCR increases will likely be required next year. The extent and timing of the rise in the policy rate will depend largely on the degree to which the momentum in the housing market and construction sector spills over into broader demand and inflation pressures.”
September MPS: CPI inflation has been very low over the past year, partly reflecting the high New Zealand dollar and strong international and domestic competition. However, inflation is expected to rise towards the mid-point of the 1 to 3 percent target band as growth strengthens over the coming year.
OCR increases will likely be required next year. The extent and timing of the rise in policy rates will depend largely on the degree to which the momentum in the housing market and construction sector spills over into broader demand and inflation pressures. We expect to keep the OCR unchanged in 2013.
The difference: There's not much change here. The bank is still saying it will keep the OCR on hold this year and rate increases are likely next year. The big difference in today's statement is higher up with the comment about the high exchange rate giving the bank some flexibility.
Economist and market reaction
Economists said the statement was broadly as expected, although some noted a lack of doveishness and a lack of an explicit warning about the currency being over-valued. The main news in the reaction was the decisions by Westpac and BNZ economists to delay their OCR hike forecasts to April and June respectively from March.
The New Zealand dollar wobbled through the morning, falling before 9 am on the Fed's decision, but then bouncing on perceptions the bank had not been as dovish as some thought it might be. It remains broadly where it was late yesterday.
ASB Chief Economist Nick Tuffley said he still expected the OCR to be lifted in March next year.
The RBNZ continues to refrain from labelling the high NZD as overvalued, likely reflecting the fact that global dairy prices are also at very high levels. The RBNZ was explicit on the implications of the higher NZD for monetary policy: it dampens inflation pressures and allows the RBNZ greater “flexibility as to the timing and magnitude of future OCR increases”.
This implies that, if the NZD remains at high levels into early next year it may delay the timing of the first OCR increase (the RBNZ has previously indicated March/April 2014). The higher NZD would also reduce the extent of OCR increases, which would bring the RBNZ’s expectations of OCR increases closer to our own (from 200 basis points of increase over 2 years, to our expectation of 150 basis points over 2 years).
Westpac Chief Economist Dominick Stephens formally changed his forecast for the first OCR hike to April next year from March.
Overall, this OCR Review was exactly in line with our expectations. Interest rate markets were similarly unsurprised, and did not react to the Review. The exchange rate rose about 40 pips (rather inexplicably, in our opinion).
As we foreshadowed last week, we are altering our own OCR forecast. We now expect the RBNZ will begin hiking the OCR in April next year (previously March). We still believe the economy is going from strength to strength. But the exchange rate is now uncomfortably high, and we expect the TWI will be above 78 next March. At those levels, we doubt that the Reserve Bank will be prompted into hiking the OCR early.
ANZ Chief Economist Cameron Bagrie also noted the bank's comments on how the high New Zealand dollar would help to keep inflation down.
The qualitative assessment is similar to the September MPS, with the RBNZ signalling the likelihood of OCR increases over 2014, but a moderate inflation backdrop and offsetting shocks are providing the Bank the opportunity to remain on the sidelines for a while yet. While there is some more explicit currency-related conditionality in terms of where the OCR could go over 2014, the bigger picture is one of business as usual. With the economy now expanding solidly, OCR increases are inevitable at some stage. We expect the OCR to move up from the first half of 2014, but with the pace of policy tightening over the next couple of years to be modest compared to previous cycles.
The RBNZ's affirmation that they "expect to keep the OCR unchanged in 2013" will keep the debate alive as to when in 2014 the RBNZ will kick off the tightening cycle. With just over 50% odds of a 25bp OCR hike price in for March, we see little room for an extension of the recent rally in front end rates, particularly now that the RBNZ is focusing on slightly stronger growth, and is paying more attention to inflation expectations. This should put a floor under interest rates.
But we are not bearish on interest rates, particularly given that market expectations are still broadly consistent with the RBNZ's September MPS projections, and today's greater emphasis on the exchange rate. In today's assessment, the Bank noted that “sustained strength in the exchange rate that leads to lower inflationary pressure would provide the Bank with greater flexibility as to the timing and magnitude of future increases in the OCR”. This is a small but explicit advance on what was said in September (when they said “a lower [exchange] rate would reduce headwinds”), and thus more explicitly ties policy decisions to the exchange rate. We therefore still need to be cognisant of what the NZD is doing, and with the Fed in a holding pattern, and US data going through a soft patch, the NZD is likely to be well supported into year end, taking some pressure off interest rates.
BNZ Head of Research Stephen Toplis said in a note titled "The MCI is dead. Long live the MCI!" that he had shifted his forecast for the OCR hike to June from the March quarter. He was referring to the Monetary Conditions Index (MCI), a short-lived tool used by the Reserve Bank from 1997 to 1999 that measured the combined impact of interest rates and the exchange rate on monetary policy. Here's the RBNZ history of the MCI (paragraphs 27-37)
There was only one point of difference in today’s OCR review compared to the RBNZ’s September missive and that was the acknowledgement that the strong NZD is threatening to postpone the RBNZ’s tightening cycle. We think the balance of risk is very much skewed in this direction, which argues strongly for us delaying our own published tightening cycle from March to June.
JP Morgan Economist Ben Jarman noted the bank's comments about the tradeoffs between a strong currency and interest rates. He said he expected the Reserve Bank to wait until the June quarter of next year before hiking.
Nothing presented here changes the story for policy in 2014. With the momentum in the data and the recovery quite well-entrenched, our sense is that the focus for markets will be in judging whether the rates and currency settings are balanced, and refining each with respect to the other when they become mutually inconsistent, taking into account the impact of LVR restrictions. We expect the first rate hike to come in 2Q14, with 75bp of tightening to be delivered in total in 2014.
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(Updated with economist reaction, market reaction, chart)