OCR Review: RBNZ Cuts By 50Bp To 2.50%

• The RBNZ cut the OCR by 50bps as expected, and said rates will remain at 2.50% or below for a long time.
• The outlook for the global economy has deteriorated further, and financial conditions in New Zealand have remained tighter than the RBNZ expected.
• We continue to expect a low in the OCR of 2% this year

This morning the RBNZ cut the cash rate by 50bps to 2.50%. This was expected by the majority of analysts, while market pricing was split about evenly between a 25 and 50bp cut. However, the RBNZ's commitment to keeping interest rates low was much firmer than we or the market anticipated.

The outlook for world growth has deteriorated further since March. Despite talk of 'green shoots' in the economy (which mostly consist of activity falling at a slower pace), hopes for a near-term recovery are fading rapidly. Consensus growth forecasts for New Zealand's major trading partners have been revised down to -2.2% for this year and +1.6% for next year; using recent forecasts by the IMF, whose relative gloominess on the Asia-Pacific region seems to be more in line with the RBNZ's thinking, gives an expected 2.8% fall this year and a miserly 0.8% rebound next year.

The RBNZ also cited the sharp rise in long-term interest rates and the exchange rate since the March MPS. The fact that the RBNZ took the unusual step of issuing an inter-meeting statement in early April, noting that the rise in long-term rates was 'unwarranted', just shows how much this de facto tightening threatens their projection of an economic recovery from the second half of 2009. Notably, the RBNZ still regards financial conditions as too tight even though long-term rates had reversed about half of their gains since early April (although bank lending rates hadn't moved ahead of today's decision).

Today's statement gave two important clues about future OCR moves. First, it stated that further policy stimulus was seen as 'appropriate' and that 'the OCR could still move modestly lower over the coming quarters'. This is more dovish than the March MPS, where they noted that 2.5% was the expected low point in the OCR, and expressed reservations about going much lower than this.

The statement was perhaps even more notable for what it didn't say: there was no mention of the idea that New Zealand's interest rates needed to 'remain competitive in international capital markets'. To this we can only say 'thank goodness' - this never made sense to us in the context of OCR decisions. International investors are more concerned with longerterm rates than with the cash rate, and if they demand a premium for lending to New Zealand, the market will give them one.

The second clue was that they 'expect to keep the OCR at or below the current level through until the latter part of 2010' - taking the lead from other central banks such as the Bank of Canada, who have made explicit pledges to keep interest rates low until a particular date. The purpose of this is twofold: it helps to keep a lid on longer-term interest rates, if the market believes that rate hikes are a long way off; and it gives borrowers more confidence to remain on floating or short-term fixed rates, where they will receive more of the benefit of recent (and any future) OCR cuts.

We expected the RBNZ to strengthen their language around keeping rates low for an extended period, though we didn't expect them to be so specific. There is a benefit to this approach, in terms of making their commitment to low rates seem more credible. The downside is that they could end up making a rod for their own backs, if they find themselves having to change this date in the future. Projections of future policy settings are always highly conditional on events, and in this extremely uncertain environment it's tough to make a firm commitment one way or another. Nevertheless, we'd award full marks to the RBNZ for today's statement.

Market implications

The 50bp cut was larger than what the market had factored in, and the commitment to keeping rates low a lot more dovish. Two-year swap rates have fallen by 25bp to 3.40%, while NZD/USD fell by more than a cent to 0.5640. The RBNZ will probably be happy with what today's statement has achieved: longer-term wholesale rates have eased, and they have made it clear that the short end of the yield curve will remain more favourable for borrower for some time to come

We expect further rate cuts this year, though with the RBNZ already anticipating a lot of bad news to come on the world economy, the hurdle for large cuts is getting higher. We are sticking with our pick of 25bp cuts at each of the June and July reviews, taking the OCR to a low of 2%.

RBNZ press release

The Reserve Bank today reduced the Official Cash Rate (OCR) by 50 basis points to 2.5 percent.

Reserve Bank Governor Alan Bollard said: 'Overall, developments since March point to lower medium-term inflation than previously projected. The main factors behind this are weaker global growth, and an unwarranted tightening in financial conditions via both higher long-term interest rates and a stronger exchange rate than expected.

'Global financial markets have showed some tentative signs of stabilisation since the March Monetary Policy Statement and governments in the major economies are continuing to make progress in resolving their banking system difficulties. However, a large amount still needs to be done and sentiment remains fragile. Negative feedback from the global recession could also still adversely affect financial institutions.

'The world economy deteriorated further than expected in the first quarter of 2009. While monetary and fiscal policy responses in many countries have been substantial and there are some signs of stabilisation in some countries, we still expect the adverse economic forces generated by the crisis to remain dominant throughout 2009. The timing and extent of global recovery remain highly uncertain.

'While the New Zealand economy has not experienced the same extreme falls in economic activity as seen in a number of our trading partners, it remains weak. Business sentiment is low, investment has been curtailed and employment reduced.

'We expect the large decline in the OCR over the past year to pass through to more borrowers over coming quarters as existing fixed-rate mortgages come up for re-pricing. This, together with the stimulus from fiscal policy, will act to support the New Zealand economy and eventually see activity trough and pick up thereafter. However, the scale of the global financial crisis and domestic adjustments underway are such that it is likely to be some time before economic activity returns to robust and healthy levels.

'We consider it appropriate to provide further policy stimulus to the economy. We expect to keep the OCR at or below the current level through until the latter part of 2010. The OCR could still move modestly lower over the coming quarters.'

Westpac Institutional Bank
http://www.wib.westpac.co.nz/

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