RBNZ June Monetary Policy Statement: OCR on Hold at 8.25%; Dovish tone

We're all going on an inflation targeting holiday

• OCR on hold but RBNZ signals it expects to be cutting by the end of this year.
• While we don't think it would be particularly clever policy, we now expect the first rate cut in September.
• The RBNZ has slashed its forecasts for economic growth. However, inflation is higher throughout the forecast horizon, peaking at 4.7% in Q3 (we expect 4.5%). Inflation is forecast to average 3.4% over the next 3 years.

The Reserve Bank of NZ maintained the OCR at 8.25%, but stated that they expect to be cutting interest rates by the end of the year. With strong inflation on the one side, and a nasty economic slowdown on the other, the RBNZ has chosen to take the risk on inflation, justifying this with what we view as unrealistically pessimistic forecasts for medium-term economic growth. We see a strong risk that inflation expectations could soon lose their last tenuous grip on the inflation target.

The tone and forecasts in the June Statement presented an even more extreme mix of weak growth and high inflation than the March Statement, or the OCR review in April.

As expected, the RBNZ have revised down their near-term growth forecasts for GDP substantially (Figure 1). Annual average GDP growth was anticipated to be 1.9% in the year

to March 2009; this has now been revised down to 0.9%. This makes sense. However, we take issue with the extremely pessimistic growth outlook for the following couple of years. The weakness is focused in consumption, though investment has also taken a hit.

Business investment is weak in response to weaker household spending, tight credit conditions, poor profitability and a weaker exchange rate making imported investment goods more expensive. Residential investment is now expected to be dramatically weaker (Figure 2). We're a little surprised by the size of the downward revision here (some 12% over the next couple of years). If anything, housing market activity has been falling at a more moderate pace than looked possible a few months ago, and building consents rebounded strongly in April.

Turning to consumption: despite the tax cuts announced in this year's Budget, the RBNZ is assuming a deep retrenchment: annual average consumption growth is forecast to be only 0.4% in the year to March 2009, -0.2% to March 2010, and astonishingly, still only 0.1% in the year to March 2011 (Figure 3). Assuming population growth of around 1%p.a., the RBNZ is expecting 3 years of deep per capita recession in the consumer sector. This at a time of a terms of trade boom and the biggest fiscal stimulus in ten years! Part of the reason is a larger fall in the housing market - house prices are now expected to fall 13% peak to trough (a 23% inflation-adjusted correction in 3 years). Other factors include the decline in the terms of trade, ongoing high effective mortgage rates, high global food and energy prices and a falling currency. Given the fairly catastrophic consumption forecast, it is only the assumption of a sharply lower exchange rate boosting net exports that saves the GDP growth forecasts from looking very sick indeed.

But while growth may be much weaker, the inflation outlook just keeps getting uglier. Inflation is now forecast to average 3.4% over the next three years. Inflation remains above the target band throughout next year, and is still above 2.5% in 2011. This is despite some very optimistic assumptions: that world oil prices will come off quite sharply, and that inflation expectations “will not move much higher in response to the temporary near-term spike” in inflation (to a whopping 4.7% in Q3). Indeed, in the Policy Assessment the RBNZ amusingly note their expectation that “inflation expectations [will] remain anchored”. Anchored to what? Surely not the inflation target mid-point. In recent years they've been tied to a rocket (Figure 4). According to their own model for inflation expectations, the RBNZ inflation forecast would suggest 2-year ahead inflation expectations will rise to at least 3.3% - yet this doesn't appear to faze them.

Cost-push shocks force inflation-targeting central banks into a trade-off between stabilising inflation and stabilising output in the near term. The RBNZ has given growth the benefit of the doubt over recent years, and inflation expectations have drifted upwards as a result. Nonetheless, the RBNZ has today shown it is willing to continue to assume that inflation expectations will “remain anchored”. This is simply not credible, in our view. Yes, housing is dead. The labour market is turning. Businesses and consumers are miserable. The NZD is extremely high. But when the central bank is itself forecasting inflation to average 3.4% over the next three years, why should businesses and consumers take the midpoint of the inflation target as any kind of guide to what inflation is likely to be in the years ahead? The Reserve Bank is digging itself into an ever deeper hole.

So has the RBNZ walked away from their inflation target? They would say not. In a Box on “maintaining price stability in trying times” the RBNZ state “we will adhere to the medium-term inflation target, because to allow inflation expectations to rise substantially would require a painful economic adjustment later to restore price stability”. Fine words indeed. Shame they aren't consistent with the RBNZ's own forecasts.

In the medium term, CPI inflation is expected to fall as these price shocks drop out of the equation and growth slows (Figure 5). However, by the end of the forecasts, early March 2011, CPI inflation is still forecast to be above 2.5%. The RBNZ note that the CPI excluding food and energy prices (just) remains within the target band. But what does this series represent, in a food-producing and oil-importing nation? Not living costs. Not income growth. Not anything useful, in fact.

We see the risks around the inflation forecasts as skewed strongly to the upside. The RBNZ are assuming that even if workers would like compensation for sharp cost of living increases, employers will be in no position to deliver it, and hence the economy will not go into a 1970s-style wage-cost push spiral. We hope they're right, but aren't convinced.

The RBNZ published a 90-day rate projection that was considerably lower than the March MPS track (Figure 6). This corroborates the RBNZ's comment that “we are now likely to be in a position to lower the OCR later this year.” While we and the market were very startled by the dovishness of this comment, the RBNZ must be taken at their word. Accordingly, we have brought forward our expectation of the first OCR cut to September this year. We continue to expect only three cuts: we believe by early next year the RBNZ will be realising that inflation and inflation expectations are getting away on them.

Market implications

The market was set for no change in rates, but was not expecting such a blatantly dovish tone. The RBNZ has given the market carte blanche to price in rate cuts as soon as they like. The NZD fell about a cent and the two year swap rate fell 30 basis points. For now, the market is pricing in nearly a 40% chance of a cut in July. A cut is fully priced in for September, another in October, and a good chance of a third by the end of the year. We expect the market to drift downwards once more from here in response to ongoing weak data, punctuated by jumps in response to stronger inflation indicators.

Brendan O'Donovan, Chief Economist, Ph: (64-4) 470 8250

Sharon Zöllner, Markets Economist, Ph: (64-4) 381 1412

Monetary Policy Statement June 2008 - Policy Assessment

The Official Cash Rate (OCR) remains unchanged at 8.25 percent.

The global economy is currently experiencing significant increases in oil and food prices. These price increases are occurring at the same time as activity is weakening in many economies in response to the global credit crisis and slowing housing markets. In New Zealand, this confluence of factors is producing a challenging environment of weak activity and high inflation.

We project annual CPI inflation to peak at 4.7 percent in the September quarter of this year. Although much of this reflects higher food and energy prices, underlying inflation pressure also remains persistent. Nevertheless, we do still expect inflation to return comfortably inside the target band over the medium term. This is based on the that commodity prices stop rising, inflation expectations remain anchored, and weakening economic activity contributes to an easing in nontradable inflation.

The outlook for economic activity is now weaker than in our previous Statement. We project little GDP growth over 2008, and only a modest recovery thereafter, largely reflecting a weaker household sector. Government spending and personal tax cuts will provide some offset to this lower growth but will also add to medium-term inflation pressure.

Consistent with the Policy Targets Agreement, the Bank's focus will remain on medium-term inflation. Provided the economy evolves in line with our projection, we are now likely to be in a position to lower the OCR later this year, which is sooner than previously envisaged.

Westpac Institutional Bank

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