RBNZ July 24 OCR Preview: Staying at 8.25%, for now

Should I stay or should I go?

• The RBNZ's June Monetary Policy Statement indicated that they will be in a position to lower the OCR later this year. With growth deteriorating further since then, market opinion is divided as to whether they will start in July or September.
• It will be a finely balanced decision, but we favour a September move. The RBNZ clearly set out a slow and steady approach in their June Statement, balancing the risk of a sharper growth slowdown against the risk of having to make an embarrassing policy U-turn if inflation fails to moderate. We don't think enough has changed since then for the RBNZ to abandon their plan.

In their June MPS, the Reserve Bank surprised us with their willingness to signal a series of rate cuts starting later this year, even with annual inflation forecast to reach 4.7% (which would be the highest rate since 1990) and to average above 3% for the next three years. Since then, the near-term growth outlook has deteriorated further, and the market has grown more confident that rates are coming down - it looks likely that, for the first time in years, the RBNZ will go into next week's decision with markets putting better than even odds on a rate cut.

We certainly wouldn't rule out a July cut. But there is more at stake than a matter of timing. The RBNZ is about to embark on a new easing cycle that could be drawn-out or short-lived; the risks around both inflation and growth are as high as they've ever faced; and markets will take the RBNZ's first move as a sign of how it means to continue. The best way to balance these risks is to signal a slow and steady series of rate reductions.

In June the RBNZ projected over 200 basis points of cuts over the next few years - but weighted more towards the later years, once they see inflation more comfortably within the 1-3% target band (Figure 1). And when presenting the MPS to Parliament, RBNZ Governor Bollard noted that “our numbers are consistent with, for example, a cut in September and, for example, another cut in December”. Looking back at past statements, we can't find a single instance where he has been this explicit about his next move and hasn't delivered on his word.

If I stay there could be trouble

So the case for a July rate cut rests on whether conditions have changed enough since June for the RBNZ to abandon its longterm plan. The downside risks have certainly increased:

Growth - The economy was knocked for six in the first half of this year by drought, higher interest rates, tighter credit and soaring energy prices. GDP fell by 0.3% in the March quarter, in line with the RBNZ and market forecasts, and all indications are that the June quarter was even worse. The Westpac survey of consumer confidence fell to its lowest level since the 1991 recession, while the NZIER survey of business opinion went one better - firms' own activity expectations fell to their lowest level since 1982. Add to this the ongoing slump in the housing market, falling retail sales and further increases in fuel prices, and there's been little to cheer about recently.

We expect Q2 GDP to shrink by 0.5%. In contrast, the RBNZ's June forecasts implied a 0.2% gain, and more recently Dr Bollard suggested that it would be “roughly flat”. The stigma of a 'technical' recession is not in itself a reason to cut early - there is nothing the RBNZ can do in July to improve our growth performance between January and June - but a weaker starting point for GDP will take some pressure off their medium-term inflation forecasts.

Global - Consensus forecasts for world growth have been revised down slightly for 2008, but more significantly for 2009. Normally, this would reduce the RBNZ's inflation forecasts, mainly through lower commodity prices. But like us, the rest of the world is not experiencing a 'normal' shock. Rising prices, especially for food and fuel, are boosting inflation as well as contributing to the slowdown in growth, leaving central banks around the world with an uncomfortable trade-off. The recent fall in oil prices still leaves them higher than where the RBNZ assumed they would peak.

Credit - The global outlook is further complicated by renewed fears in credit markets. The US banking sector in particular has been under fire, and concerns about the solvency of the mortgage giants Fannie Mae and Freddie Mac saw global share markets plunge. The immediate impact here has been an increase in the premium paid for offshore funding, which had started to moderate in recent months. This in turn raises the question of whether OCR cuts would be passed on to borrowers.

Access to international funding is a key risk, but the situation is very fluid. For example, since June, US banking stocks have fallen by 40%, then recovered by 33% as authorities expressed their support for the mortgage giants. This is another case where the RBNZ will be wary of rushing into action, knowing that conditions could be different again in six weeks' time.

If I go there could be double

One thing that hasn't changed is the risk of creating fresh problems further down the track. The RBNZ was already forecasting inflation to peak at 4.7% in the September quarter; now it seems it will be more like 5.5% (Figure 2).1 And that's without considering the likely effects of an aggressive easing, the first of which would be a sharply lower currency. This would see near-term inflation shoot even higher, and probably wouldn't do a lot for confidence either - we doubt that consumers and businesses would appreciate petrol at $2.50 a litre or more.

More worrying for the longer term, it would give people little reason to believe that inflation will average anything like 1-3% in the future. The RBNZ is already hoping that high headline inflation won't flow through to expectations - or, if it does, people won't be able to act on this by raising their prices or demanding a pay rise. The RBNZ's view may prove to be right, but history is against them.

You don't have to look far to find other central banks that have painted themselves into a corner by easing aggressively. US inflation has reached 5% and is likely to head higher, UK inflation is expected to reach well over 4% this year, and the Bank of Canada now expects inflation to peak above 4% next year, more than double what they thought three months ago. In each case, the central banks have curtailed their easing, even as their economies flirt with recession.

In contrast, consider what the RBNZ has achieved so far by signalling a gradual approach. The New Zealand dollar has seen a relatively orderly decline - the trade-weighted index has held to a 67-68 range since the June MPS, from around 70 beforehand. And they have been able to bring down long-term interest rates, without having to over-commit to any action on short-term rates. The two-year swap rate is more than 100bp below its peak, and crucially, this is being passed on to retail borrowers, with mortgage rates for the most popular fixed terms down as much as 50bp since April.

The biggest advantage of a 'slow and steady' approach is that it minimises the risk of having to make an embarrassing policy reversal. If the economy recovers quicker than thought and/or inflation expectations get out of control, the RBNZ can simply shift to an on-hold stance with the OCR still at a relatively high level. Likewise, if the exchange rate falls dramatically the RBNZ can slow the pace of cuts.

We think this caution will prove to be warranted. By early next year, there will be more evidence that the economy has passed through the downturn and is regaining momentum, and the RBNZ will no longer be able to look past the persistently high headline inflation rate or the rise in inflation expectations.

So c'mon and let me know

Next week's OCR decision will be finely balanced. But while the market is largely focused on the timing of the first move, the RBNZ is clearly concerned with stage-managing the whole of the easing cycle. What sways us towards a September move is that the softer growth picture since June doesn't diminish the risk of creating new problems by easing more aggressively than the market expects.

Even with no move next week, the RBNZ will probably confirm that they are on track to cut in September. In this case the market response will be limited - wholesale interest rates could jump as much as 10bp on the day, but would soon find their way lower again. Similarly, the NZD could spike higher, but only within the realms of typical day-to-day volatility.

A rate cut next week would have a more enduring impact than an on-hold decision. Market interest rates are already factoring in an extended easing cycle, but once the RBNZ moves, the market is likely to assume further cuts at every meeting for the foreseeable future. Two-year swap rates could fall by 10-12bp on the day, and will continue to trend lower from there.

Westpac Institutional Bank

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