RBNZ Dec Monetary Policy Statement: OCR Cut By 150bp To 5.00%

Actions speak louder than words

• The RBNZ made another jumbo-sized cut to the OCR, bringing the rate to its lowest level in nearly five years.
• The RBNZ made moderate downgrades to its growth and inflation forecasts, and acknowledged further risks to the downside. Governor Bollard chose to act on those risks now, by continuing to ease rates aggressively.
• We still expect a trough in the OCR of 4.00%, though that point will now be reached sooner

Today the Reserve Bank delivered another aggressive cut to the OCR, in response to the continuing turmoil in global markets and a rapid deterioration in the outlook for world growth. Today's move means that the 2004-2007 tightening cycle has been completely reversed in the space of less than five months. The size of the cut was at the top end of analyst expectations, and was broadly in line with market pricing.

The Monetary Policy Statement itself revealed only moderate downgrades to the RBNZ's growth and inflation forecasts, and gave no strong signal about further easing. However, they acknowledged that there are substantial downside risks to their forecasts, and even more so in light of the most recent news on the global economy. So as an indicator of future policy moves, the Statement was arguably out of date already by this morning. We prefer to read more into RBNZ Governor Bollard's actions - he continues to err on the side of larger rate cuts, and to leave the door open for more to come

The statement

The press release was largely focused on justifying today's massive rate cut, noting that deteriorating global conditions were a key factor. Weaker global growth and reduced inflation pressures will inevitably flow through to New Zealand, which will help to bring inflation back within the 1-3% target band. The statement argued that rapid easing is appropriate 'to support the economy and keep inflation from falling below the target band', which probably overstates the case.

The RBNZ pointed out that the OCR is now clearly below neutral levels. Combined with the weaker exchange rate and recent fiscal stimulus, overall policy settings are now providing substantial support to demand. However, this is appropriate to the conditions, with global forces acting as a substantial drag on demand at the same time.

The statement concluded that: 'Further movements in the OCR will be assessed against emerging developments in the global and domestic economies and the response to policy changes already in place'. With the risks to the growth outlook seemingly stacked to the downside, this suggests scope for further easing.

Forecasts

The details of the Monetary Policy Statement were roughly in line with our own forecasts, though we thought the RBNZ's forecasts might have been weaker. Indeed, they acknowledged that the latest business activity indicators from around the world, published in the last week or so, have deteriorated even more than expected, and would add further downside to their forecasts.

Consensus forecasts for world growth have been slashed since September, particularly for the developed economies, with the US, Japan and Europe all expected to contract next year. Overall, New Zealand's major trading partners are expected to grow just 1.1% in 2009, the slowest pace since the early 1980s.

New Zealand is expected to buck the trend a little, by recording shallow growth in 2009 after spending most of this year in recession. The RBNZ's near-term forecasts are little changed since September - they expect (as we do) another 0.3% decline in Q3, followed by a small consumer-led gain in Q4. Growth forecasts for the year to March 2010 were cut from 1.9% to 1.3%, also in line with our forecast.

Their pick for 4.3% growth in the year to March 2011 seems optimistic, but it reflects the idea that there will be a substantial amount of spare capacity in the economy by then, ready to be absorbed. We're not so sure about this judgement. In the past four years, inflation has exceeded expectations even as growth has undershot, suggesting that the New Zealand economy's 'potential growth rate' is lower than the RBNZ believes

Real household consumption forecasts were revised up compared to September, as lower than anticipated interest rates and fuel prices leave more money in people's pockets. Residential investment was revised even lower, in light of the continued slump in building consents, and business investment is expected to contract significantly over the next year. On the plus side, government spending will continue to provide support (though increased infrastructure spending is more of a story for 2010) and net exports are expected to start making a positive contribution to growth from next year.

Inflation is set to swing from one extreme to another, reflecting the dramatic rise and subsequent collapse in oil and other commodity prices this year. The annual rate is expected to fall from the peak of 5.1% in September this year to a low of 1.6% in September next year. Beyond this, though, inflation is expected to remain in the upper half of the target range over the medium term. This is no real surprise - as we have noted before, the RBNZ's inflation forecasts are contingent on their interest rate projections, and if inflation were at risk of falling towards the lower edge of the target band, they could simply top it up with more easing.

The RBNZ notes that there are still substantial inflation pressures in the pipeline. They expect to see import prices rise soon as a result of the sharp fall in the currency (prices of manufactured goods, for example, are unlikely to fall by anywhere near the same extent as commodity prices). They also concede that inflation pressures in non-competitive areas of the domestic economy - electricity and council rates were singled out again - are likely to persist for longer than they previously thought.

With the new National-led Government placing the Emissions Trading Scheme (ETS) under review, the RBNZ has based its forecasts on the assumption that the ETS will not be implemented. That seems a fairly brave assumption at this stage, given that the ETS would first have to be expunged from law, then presumably replaced by something else, such as a carbon tax, in order for New Zealand to meet its Kyoto obligations. If the ETS were retained as is, the RBNZ would be projecting annual inflation to reach 2.7% through 2010 - again, a far greater risk of breaching the upper than the lower end of the inflation target.

The interest rate track is where the need to distinguish between the RBNZ's words and their actions is most apparent. The MPS projects the 90-day rate to average 5.5% over the first quarter of next year, easing to 5.1% by Q4, before beginning a slow climb back towards neutral levels. However, the 90-day rate had already fallen to 5.3% before today's decision, and by endorsing market pricing for a 150bp cut, the RBNZ has ensured that rates will keep heading lower from here.

So as a guide to policy decisions over the next few months, the MPS projections are fairly unhelpful - though if we set the exact numbers aside, the tone of the statement and the press release were both geared towards the message that further easing is likely

Market implications

We maintain our view that the RBNZ will bring the OCR to a low of 4.00% next year, with 50bp cuts in each of the January and March reviews. While the RBNZ's projections were more consistent with a low of 4.50%, they admitted that the risks to this were heavily skewed to the downside, and today's massive cut has already put 90-day rates onto a lower track than they projected.

Interest rate markets are factoring in a low for the OCR of 3.75%, as they were before today's announcement. We're comfortable with the idea that market pricing will continue to undershoot our OCR forecasts, as they have yet to be given any reason to anticipate an end to the easing cycle.

Interest rates ended the day little changed - the initial instinct was to push rates lower, with the two-year swap rate touching a record low of 4.8%, but this move couldn't be sustained, and profit-taking emerged later in the day to push rates higher again. NZD/USD rose from 0.5280 to 0.5330 after the announcement, in keeping with the recent experience around the world - currency markets have tended to treat a proactive central bank more positively than a wide interest rate differential.

Monetary Policy Statement December 2008 - Policy Assessment

The Reserve Bank today reduced the Official Cash Rate (OCR) from 6.5 percent to 5.0 percent.

Reserve Bank Governor Alan Bollard commented that 'ongoing financial market turmoil and the marked deterioration in the outlook for global growth have played a large role in shaping today's decision. Activity in most of our trading partners is now expected to contract or grow only very slowly over the next few quarters.

'Economic activity in New Zealand will be further constrained as a result, compared with our view in October.

'Inflation is abating here and overseas as a consequence of these developments. We now have more confidence that annual inflation will return comfortably inside the target band of 1 to 3 percent some time in the first half of 2009 and remain there over the medium term. However, we still have concerns that domestically generated inflation (particularly local body rates and electricity prices) is remaining stubbornly high.

'Today's decision brings the cumulative reduction in the OCR since July to 3.25 percent, and takes monetary policy to an expansionary position. Given recent developments in the global economy, the balance of risks to activity and inflation are to the downside. Thus it is appropriate to deliver this reduction quickly to support the economy and keep inflation from falling below the target band.

'Monetary policy is working together with the depreciation of the New Zealand dollar and the fiscal stimulus now in train, to provide substantial support to demand over the period ahead and to create the conditions for some rebound in growth as global conditions improve.

'To ensure the response we are seeking, we expect financial institutions to play their part in the economic adjustment process by passing on lower wholesale interest rates to their customers.

'Further movements in the OCR will be assessed against emerging developments in the global and domestic economies and the response to policy changes already in place.'

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

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