RBNZ's Bollard may hose down market expectations for Dec OCR hike, but may signal higher OCR peak later, economists say

By Alex Tarrant

The Reserve Bank is likely to significantly soften its tone in next week's Monetary Policy Statement (MPS) about the timing of the first interest rate hike to try and avoid adding further upward pressure to rates in the near term, Westpac economists say.

Markets have increasingly been pricing in a December hike in the Official Cash Rate over recent months and are eyeing a peak of between 4-4.25% in the OCR in two to three years' time. However, economists say the Reserve Bank may signal that peak to be slightly higher as bank costs for overseas funding fall back.

Reserve Bank Governor Alan Bollard may also note the high New Zealand dollar, which, although acts as a drag on the export sector, helps contain inflation by keeping down the prices of imported goods, therefore reducing the need for interest rate rises.

Three of the four major trading banks are tentatively picking the resumption of OCR hikes to be in December this year (for example, ANZ economists say on hold until "at least" the end of this year), after global events and tepid local growth constantly pushed out that timing through 2011. BNZ economists say their official view is for a rate hike in September, although they note the risks to this view are "definitely toward a later start to the process".

Markets are pricing in over a 50% chance the Reserve Bank will raise the OCR by 25 basis points in December from its current record low of 2.5%, Westpac economists said. The Reserve Bank is expected to keep the OCR on hold this Thursday when it reviews the rate and releases its latest quarterly forecasts at its March Monetary Policy Statement, all 15 economists polled by Reuters say.

The inflation and interest rate outlook is crucial for borrowers considering whether to fix or float, given fast and early OCR hikes make fixing more attractive, while later and slower hikes make floating more attractive. Westpac said on Friday now was the time to fix.

"The RBNZ will be significantly softening its message just as financial markets are starting to embrace the idea of rate hikes, with just over half a chance of a December hike priced in. Moreover, the improving sentiment towards the global economy means that the market seems more predisposed toward pushing interest rates higher. We suspect the RBNZ will want to err on the side of a softer tone to next week’s statement, to avoid adding further upward pressure to rates in the near term," Westpac economists said.

ANZ economists noted this week that the market was running the chance of pricing in unrealistically high odds of rate hikes beginning in December. ANZ economists said they doubted next week's Reserve Bank statement would be as hawkish as the market, especially with the New Zealand dollar, measured on a Trade Weighted Index (TWI) basis, as high as it is. The TWI is the basket of currencies the Reserve Bank follows (see chart here). The TWI has risen 7.2% to a six month high since the Reserve Bank's December quarter MPS.

Inflation pressures on horizon

Economists noted inflation was not likely to pick up significantly this year, as the recovery remained slow and the Christchurch rebuild was pushed back. However there might be some pressures on the horizon.

"Until reconstruction work gets under way in earnest the domestic inflationary picture will likely remain benign. Recent economic data indicate the recovery continues at a very gradual pace, although there are one or two indicators that suggest an uptick in household demand. This could pose a threat to the inflationary outlook and is something the RBNZ will keep a close eye on," ASB economists said.

Westpac economists said they thought weaker inflation would receive the strongest emphasis from the Reserve Bank in the Monetary Policy Statement.

"The December quarter CPI was much softer than expected (actual -0.3%, RBNZ forecast +0.4%), the second undershoot in a row. And with the impact of the October 2010 GST hike (which added around 2 percentage points) finally dropping out of the calculation, annual inflation fell from 4.6% to 1.8%, well within the 1-3% target range," Westpac economists said.

"It’s worth bearing in mind that the current inflation rate isn’t that far from what was forecast a year ago. However, prices rose much more than expected in the first half of 2011, and did so in areas (such as construction costs) that looked as though they could be quite persistent. Annual inflation spiked to a 20-year high of 5.3% (including the GST impact), and surveyed inflation expectations followed suit, reaching a peak of 3% for two years ahead," they said.

"By July, the RBNZ was warning that an OCR hike was imminent. But the worsening in global financial conditions stayed the RBNZ’s hand, which proved to be fortunate: inflation pressures were much tamer in the second half of the year, and inflation expectations have also moderated.

"We now expect annual inflation to fall as low as 1% by the middle of this year – partly a legacy of the soft outturns in the last two quarters – before returning just above 2% by year-end. With such a benign near-term inflation outlook, the RBNZ will be very comfortable waiting to see how some of the other risks to the economy resolve themselves," Westpac economists said.

Where will it end up?

BNZ economists said they thought the market might be underpricing the peak of the OCR and the speed of rises. The Reserve Bank's December Monetary Policy Statement suggested the OCR might peak around 4% in 2014.

"Once the RBNZ gets underway, we see a gradual process toward “normalizing” rates. We see the OCR peak at 4.25% at the end of 2013. By contrast, the swap curve is currently consistent with an OCR that peaks at 4.00%-4.25%, but not until the end of 2015," BNZ economists said.

"Our expected peak in the OCR rate is very low on an historic basis. This is in acknowledgement that bank funding costs have risen significantly since 2009. This is due to the implementation of the RBNZ's BS13 Liquidity Policy that requires banks to extend the maturity of their bank funding. This has resulted in a step shift in bank funding costs, now creating a permanent “wedge” between the OCR and borrowing rates," they said.

"Consequently, the OCR does not have to rise as much as was the case previously to have a dampening impact on the economy. Hence our forecast for a 4.25% peak in the OCR as opposed to previous peaks above 6%."

Westpac continues to see a peak of 6% in 2015.

"One of the biggest potential channels of contagion from Europe to New Zealand is via the cost of overseas funding for our banks. In recent statements, the way the RBNZ has incorporated this mounting risk has been to assume a lower long-term ‘neutral’ level for the OCR, to counter the impact of higher bank funding costs and end up with a desired level of retail interest rates," Westpac economists said.

"With conditions improving in Europe and indicative bank funding costs coming off their peaks, the implication is that the RBNZ could reverse some of this assumption and project a higher end-point for the OCR (the December MPS suggested a peak of less than 4%). However, we expect it will move cautiously on this matter for now," they said.

BNZ economists also said they expected the Reserve Bank to take a more assertive path than was currently priced by the market.

"The RBNZ maintains a tightening bias. The starting point for rate hikes, though difficult to pinpoint with certainty, will be some time after Q3 this year. More importantly, we believe the market is under-pricing the gradual “normalization” in the OCR once rate hikes begin," BNZ economists said.