RBNZ December MPS Preview: OCR to be Cut 100bp to 5.50%

Easy does it

• The credit crisis continues to ravage financial markets, and the world economy is now rapidly losing steam. New Zealand will be hit by lower commodity prices and weaker export demand.
• The RBNZ will be aiming to bring financial conditions well into 'easy' territory. A high degree of certainty about the economic slowdown means they can move quickly.
• However, monetary policy has many friends, and we feel that a cut of 'just' 100bps would be enough to do the job for now.

Life isn't getting any easier for the RBNZ. Each time they have sat down to review interest rates this year, the global credit crisis has been deeper, the outlook for economic growth has deteriorated, and policymakers around the world have become more aggressive in their responses. Next Thursday's OCR decision will be another difficult one, though as in the October review, the case for a sizeable rate cut is a given - the question is one of tactics. We see a 100 basis point cut as the most likely option, but we admit that a case can be made for either a bigger or a smaller move in this environment.

Doom and gloom

The global credit crisis continues to unfold at an astonishing pace. The last month has seen heavy falls in commodity prices, new lows in world equity markets, and the near-failure of Citigroup, which was the world's largest bank by market capitalisation as recently as last year.

The policy response has been equally gobsmacking. Through a mix of bank capital injections, commitments to buy financial assets, liquidity facilities, and guarantees for private sector debt, US authorities have so far committed about $8.5 trillion to propping up the financial system - that's equivalent to 60% of nominal US GDP. On the plus side, these measures are finally gaining some traction. For instance, the logjam in the interbank lending market has eased since mid-October, though the cost of funding remains unusually high (Figure 1).

Perhaps more importantly, October seems to have marked the point when the credit crunch really went to work on the global economy. Recent data from the major economies have been truly terrible - in the US, the unemployment rate has soared to 6.5% and is set to rise further, industrial orders have slumped, and the decline in house prices has accelerated. Europe and Japan have both fallen into recession (two straight quarterly declines in GDP). And China, which many had hoped would provide the engine for global growth, is decelerating rapidly.

In this environment, forecasts for world growth have been slashed, with the biggest revisions coming in November. New Zealand's major trading partners are expected to grow just 1.3% in 2009, compared to a relatively comfortable 2.6% expected just two months ago (Figure 2). North America, Western Europe and Japan are expected to contract in tandem for the first time since 1982, while Australia and Asia will continue to grow, but at a slower pace than in recent years.

Central banks around the world have begun easing more rapidly in response to the threat to growth (Figure 3). The US and UK have been the most aggressive, with the Bank of England cutting by a massive 150bp earlier this month, and the Fed taking the policy rate to a record-equalling low of 1.00%. However, both central banks have struggled to get any traction on retail interest rates, due to their dysfunctional banking sectors - some fixedterm mortgage rates are higher than they were before the credit crisis began. The RBA has cut by 200bp in short order, and we expect another 75bp cut at next Tuesday's review. The RBNZ has also done its part, easing by 175bp so far, and another 100bp next week would bring the total in line with Australia (if our RBA forecast is correct).

Forecast overview

Faced with such an extreme environment, what should the RBNZ do next week? Indeed, how do they even come to a decision? The economic forecasts in next week's Monetary Policy Statement will undoubtedly argue for a substantial easing over the next year, but the question of how much to deliver on the day is far from straightforward.

New Zealand growth forecasts will be shaded down relative to September, reflecting the weaker outlook for global growth and commodity prices. The near-term outlook is unlikely to change much, with another decline in Q3 GDP and a small bounce in Q4. However, growth for 2009 is likely to be closer to zero (previously 1.5%), with any prospect of recovery pushed out to 2010.

The RBNZ's September forecasts for real household consumption were extremely weak, with a 1% fall in the year to March 2009. This figure will if anything need to be revised upward - the June 2008 outturn was better than expected, and lower fuel prices have helped to restore households' purchasing power.

It's important to recognise the RBNZ has long been aiming for a mild consumer recession, in order to ease the inflation pressures that have accumulated over several years. The difference is that, in the past, aiming for a mild recession meant keeping monetary policy tight in order to slow the economy; now, it means bringing interest rates into 'easy' territory to avoid a deeper recession.

Inflation has clearly slipped down the list of concerns for the near future. Sharp increase in fuel and food prices saw annual inflation peak at 5.1% in September this year; a reversal of these forces could see annual inflation down to 1% or less by this time next year (Figure 4). Beyond this, the RBNZ will expect weaker activity to bring medium-term inflation well within the 1-3% target range, and we tend to agree with them. An undershoot of the target over the medium term is unlikely in their forecasts - they can simply 'top up' inflation with more easing.

The 100bp cut to the OCR in October, and the promise of more to come, mean that the 90-day rate is already well below the end-point envisaged (for 2011!) in the September MPS. We estimate that the new 90-day rate projections will incorporate a cash rate of around 4.50% within the next year. With a high degree of certainty that the economy is slowing, they will have no qualms about reaching their endpoint quickly.

The big decision

The case for some quick economic stimulus is clear. When it comes to the exact size of the move, though, it's important to note that monetary policy has a lot of friends at the moment.

The first is that the monetary policy transmission mechanism is working - a crucial difference between New Zealand and the likes of the US or UK. Wholesale interest rates have fallen sharply in anticipation of steep OCR cuts, and these have quickly been passed on to retail rates (Figure 5). In fact, with a large rate cut next week a given, banks haven't waited to pass the latest fall in funding costs on to mortgage rates.

A related issue is that mortgage rates have reached a critical point: the average homeowner is now able to refix their mortgage at a lower rate than before, freeing up cash to use elsewhere. There has also been a major shift in borrowers' behaviour over this year - a growing number of borrowers have moved to terms of a year or less, in the hope of catching the bottom in rates next time. As a result, mortgage rate cuts are set to flow through to the average homeowner far quicker than rate increases did over the last few years.

The second factor is that the exchange rate is also contributing to a significant easing in overall monetary conditions. The trade-weighted index is more than 10% below where the RBNZ expected it to be in September, which has been enough to fully offset the decline in export commodity prices so far (Figure 6). We would emphasise that the fall in the currency has been completely appropriate to the conditions - the exchange rate is an important buffer for the economy, and certainly the most flexible one. A lower NZD is an important part of the policy mix, but it won't do the RBNZ's job for them on its own.

The third factor is that fuel prices have fallen significantly over the last four months, as falling world oil prices have more than offset the weaker exchange rate. Market attention has focused on the short-term disinflationary effects, but in the medium term it provides a boost to growth as well, in the same way that it was a tax on growth when prices were rising. Lower fuel prices have already seen people return to their cars (as those of us who commute into Wellington every day can attest), and it will leave more cash available to spend on other items as well.

Finally, personal tax cuts from 1 October have also left more cash in people's pockets. In fact, we expect the combination of lower interest rates, lower fuel prices and tax cuts to provide a substantial fillip to consumer spending through the last few months of this year, though it's unlikely to be sustained beyond this.

Market implications

A huge easing in overall monetary conditions is appropriate, given the size of the shock to the world economy. Market opinion is roughly divided between a cut of 100bp or 150bp next week. Our feel is that a 100bp cut, plus a weaker currency, plus lower mortgage rates, plus the sharp fall in fuel prices, plus tax cuts, is enough to tide the RBNZ over until the next review in January. However, we concede they could easily decide to do more than 'enough' - since July, they have erred towards earlier / larger rate cuts, and with the benefit of hindsight they would have little reason to regret it.

Bear in mind that a 100bp cut is still a very aggressive move. The RBNZ's statement in October put renewed emphasis on domestic inflation pressures, in an effort to hose down expectations of another move of this size. However, there was nothing in the statement that precluded a 100bp move either, and there's no doubt that the world has taken a turn for the worse since then.

Interest rate markets are pricing 140bp of easing for next Thursday. Momentum will probably see pricing swing towards a full 150bp, though the RBA could throw a spanner in the works if they cut by only 75bps on Tuesday as we expect (market pricing is around 120bps). A 100bp cut by the RBNZ would see swap rates reverse some of their most recent falls, though with the market focused on an endpoint for the OCR of 4% or less, the relentless fall in short-term interest rates should quickly resume.

In recent months, currency markets have tended to favour proactive central banks more so than large yield spreads, so a 150bp cut would probably benefit the NZD more than a 100bp move. However, currencies remain extremely volatile, and the reaction on the day is likely to be quickly overridden by developments offshore.

Westpac Institutional Bank

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