RBNZ Sep Monetary Policy Statement: OCR Cut 50bp to 7.50%, More to Come
A swift resolution
- The RBNZ cut the OCR by 50bp and intends to frontload the easing cycle.
- Inflation risks didn't go to the backburner so much as fall off the stove altogether.
- Rapid easing will deliver earlier relief to households, but the RBNZ is also headed for an earlier confrontation with the persistence of inflation pressures.
The Reserve Bank of New Zealand surprised the market again by delivering a 50bp rate cut, the first time under Dr Bollard's governorship. This marks a dramatic turnaround from the tone of the June Statement: from a gradual easing profile, consistent with 25bp cuts in September and December, with an eye to the responses from wages and inflation expectations; to plunging in with a total of 75bp of cuts so far, with every indication of more to come by year-end.
The reason for today's jumbo-sized move was made crystal clear: the RBNZ wants to deliver some relief to homeowners now. The only way to do this, in their view, was to deliver more easing than the market was expecting: wholesale interest rates were already consistent with 25bp cuts at each meeting this year, so a smaller 25bp move might have left mortgage rates unchanged.
The RBNZ emphasised that they are bringing forward the easing that they already expected to deliver - they don't see this as leading to a lower end-point for interest rates. In fact, while their 90-day rate projection for the end of this year is 70 basis points lower compared to the June MPS, it is actually 50bp higher by the end of the forecast window three years ahead (Figure 1).
With little on the horizon to hold them back, we expect the RBNZ to continue delivering cuts at a rapid pace. We are currently picking a 25bp cut at the 23 October review, but there's a good chance that it will be another 50bp move, depending on how events pan out between now and then.
As to why homeowners need some immediate relief, the RBNZ focused on three issues: tight credit conditions, weak domestic activity, and slowing world growth.
Tight credit
Since the global credit crunch began a year ago, the cost of raising funds offshore has risen significantly. Combine that with 100bp of official rate tightening in the months before the credit crunch, and the lending rates faced by households and businesses rose sharply in a short space of time. More recently, average funding costs have remained high despite a substantial fall in swap rates. The RBNZ clearly felt in the July review, and again today, that they needed to cut the OCR just to offset the rise in offshore funding costs.
The RBNZ also expressed concern that the effectiveness of OCR cuts will be muted by the prevalence of fixed-rate mortgages in New Zealand. Even with the recent falls in fixed rates, many of those loans coming up for re-fixing in coming months will be done at rates as much as 100bp higher than before. As a result, they expect the ‘effective' mortgage rate - the average rate paid on outstanding loans - to rise further through to early next year.
Even if we accept the RBNZ's view that it is the average cost of borrowing that matters most (which we don't), this ‘pipeline' effect is not what it used to be. A quick look at the RBNZ's own data shows that fixed-rate lending for terms longer than two years has dried up since the start of this year (Figure 2); homeowners are increasingly fixing for terms of a year or less, in the hope of catching the bottom of the interest rate cycle.
Rate cuts now are likely to give more bang for the buck than the RBNZ gives them credit for.
Weaker domestic growth
Even with the easing cycle being brought forward, the RBNZ expects the consumer to be under the gun over the next year or so, as they are pummelled by falling house prices, higher food and energy costs, high mortgage rates and the weaker labour market. The RBNZ is forecasting real private consumption to fall by 1.1% in the year to March 2009, and to remain at depressed levels for another year (Figure 3). On top of this, residential construction is expected to crunch in by 18.6%, and imports are expected to fall by 2.2%.
The weak consumer is an important part of the RBNZ's story because, to put it bluntly, they are counting on weak growth to fix the inflation problem for them. The RBNZ's view is that as consumer spending falls, excess supply will emerge in the economy, which will prevent workers from negotiating larger pay increases and businesses from passing on higher input costs. We're not convinced: some of the blame for the slowdown has to fall on the supply-side ‘shock' of higher food and energy prices that has hit New Zealand, and the rest of the world, in the last year or so. Weaker activity may not reduce inflation, if that weaker activity has been caused by inflation.
The fact that the RBNZ is now forecasting a technical recession is not in itself a big deal - their pick of a 0.8% cumulative decline, spread over the first three quarters of this year, differs from our view only in terms of timing. Interestingly the RBNZ expects the June quarter to be the ‘least worst' part of the recession, with a 0.2% drop in Q2 GDP (published on 26 Sep). We're picking a 0.5% fall with risks to the downside, and we suspect that the downward ‘surprise' to the RBNZ's forecasts would add fuel to the fire for a 50bp cut in October.
Weaker world growth
The RBNZ generally relies on the Consensus survey for their world growth forecasts. But on this occasion they have taken an axe to the most recent Consensus forecasts, on the basis that they take some time to adjust, and the momentum for revisions is already clearly downward (Figure 4). This is a reasonable assumption - except for the US, where forecasts by other sources are being revised up substantially.
The RBNZ also cited downside risks to growth in Asia (ex Japan), which has slowed significantly in recent months. As yet, it's not clear if these economies are genuinely coming unstuck, or are just moderating after unsustainably rapid growth in recent years - and higher food and energy prices, which have since started to reverse, will have hurt the developing economies at least as much as the developed ones. But now that the RBNZ is in the camp of slowing Asian demand, it will be some time before they have reason to change their view.
Inflation? Fuggedaboudit!
The RBNZ is taking a huge leap of faith by assuming that weaker growth will take care of the inflation problem for them. Indeed, to read the statement you would struggle to believe that the RBNZ is an inflation targeter - virtually all of the discussion was around weaker growth and difficult credit conditions. The possibility that inflation might be stronger than their forecasts didn't rate a mention until the last paragraph of the 24-page document.
And it's not as though inflation has gone away. Any evidence of weaker inflation pressures since June have been offset by a lower interest rate track, so that their inflation forecast is almost identical to the June MPS (Figure 5). Inflation is now expected to peak at 4.9% in the September quarter (today's August food price figures must have put upside risks on that forecast), and to average 3.4% over the next three years.
Annual inflation is set to reach its highest level in 18 years. Inflation expectation surveys have risen across the board, with the RBNZ's preferred two-year ahead measure now at 3.0%. All of the RBNZ's ‘core' measures of inflation are running at 3% or higher. The RBNZ itself can only see inflation down to 2.6% after three years - and they have a track record of underestimating inflation that far ahead, by an average of about 0.9%. Why should the public believe that inflation will remain within 1-3% on average in the future, when the RBNZ are doing everything they can to ensure that it won't?
By their own admission, "it is likely to be early next year before we get a clear indication of the extent to which slower activity is translating into lower underlying inflation". But that won't stop them from delivering additional rate cuts in the meantime.
Summary
Today's Statement was aimed at a speedier resolution to the economy's current woes, by bringing forward the easing cycle that they had already signalled. We think they'll get a quicker resolution, but perhaps not in the way they imagined. By delivering more relief now, they risk re-igniting the economy before inflation is comfortably back under control, and long before inflation expectations have moderated. The RBNZ's gamble that inflation will take care of itself is now likely to be exposed even sooner.
Until then, though, there is little to hold them back from delivering further cuts over the rest of this year - inflation won't do it, activity indicators remain subdued, and global credit markets are still shaky. We are currently picking a 25bp cut at the 23 October review, but there's a good chance of another 50bp move, depending on how events pan out between now and then.
Market reaction
No prizes for guessing how the market took this one. Two-year swap rates fell 20bp, effectively building in the extra 25bp of easing that wasn't priced in for today's review. The NZD fell from 0.6630 before the decision to 0.6500 by the afternoon. Nowhere in the statement was there any concern about the 6% fall in the trade-weighted index since the July review, so we can take it that recent moves have not been "excessive".
Monetary Policy Statement September 2008 - Policy Assessment
The Reserve Bank today reduced the Official Cash Rate (OCR) by 50 basis points from 8.0 percent to 7.5 percent.
Reserve Bank Governor Alan Bollard said: "The New Zealand economy is experiencing a marked slowdown, led primarily by the household sector. The outlook for the global economy has deteriorated further in the wake of continued financial market turmoil. In addition, the New Zealand business sector is coming under pressure from both rising costs and falling demand. While domestic activity is likely to pick up late this year as a result of personal tax cuts, increased government spending and rising rural incomes, we expect a prolonged period of household sector adjustment and below-average growth.
"The weakness in economic activity is expected to translate into lower inflation pressures in the medium term. Headline inflation is expected to peak around 5 percent in the current September quarter before trending down thereafter. However, food price inflation, exchange rate depreciation and higher wage costs will tend to keep headline inflation at elevated levels through 2009.
"With medium-term inflation pressures expected to ease, it is appropriate to move towards a less restrictive monetary policy stance. Compared to the June Monetary Policy Statement, we have brought forward some of the projected interest rate reduction, but have not altered the expected overall decline. We believe this response is warranted in light of the tightness of current credit conditions and the time it will take to affect the actual interest rates faced by households and businesses.
"Looking ahead, the scale and timing of further official cash rate reductions will depend on signs of declining inflation pressures and on exchange rate adjustments."
Westpac Institutional Bank
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