Weak growth trumps inflation in RBNZ's policy stance

Thursday 9th August 2018

Concerns about New Zealand's slowing economy trumped signs of emerging inflation for the central bank after Reserve Bank governor Adrian Orr said he expects to keep the official cash rate on hold for at least a year longer than previously forecast.

"We expect to keep the OCR at this level through 2019 and into 2020, longer than we projected in our May statement. The direction of our next OCR move could be up or down," said Orr in the monetary policy statement after keeping rates on hold at a record low 1.75 percent as expected.

The central bank’s forecasts now show the OCR lifting to 1.9 percent in September 2020 versus a prior forecast of September 2019. A full-rate hike is signalled by December 2020, when the benchmark rate is forecast to be 2 percent. The central bank had previously indicated it would reach that level in March 2020.

The move took economists by surprise. "The RBNZ has (finally) accepted the reality that the economy has slowed this year. Consequently, they have become more dovish on the OCR outlook. The intensity of their reaction today surprised both us and financial markets," said Westpac Banking Corp New Zealand chief economist Dominick Stephens. The kiwi dollar fell to 66.79 US cents at 3.35pm from 67.46 US cents just prior to the statement earlier today.

What changed? A key factor is slower-than-expected economic growth, according to Orr and his deputies.

"It has been softer for longer ... basically, it has been weaker so it will take longer for inflation to pick up," deputy governor Geoff Bascand told BusinessDesk. "We don't see it (the economy) building as quickly as we did before, so we are going to have to continue to support it for a bit longer," he said.

Orr said the economic slowdown "gives us more confidence that there is no immediate capacity pressure leading to the rising inflation."

Economic growth in the first quarter already unshot the central bank's forecasts and the RBNZ now expects GDP to accelerate to 2.9 percent in the March quarter of 2019 versus a prior forecast of 3.3 percent.

Among other things, tumbling business confidence - which is hovering around a 10-year low - has preyed on the central bankers' minds. "All signals are green for business investment, but there is uncertainty in businesses' minds and we are cognizant of that. Hence we have tempered our expectations for business investment," Orr told Parliament's finance and expenditure select committee.

"The new regime has clearly revealed its spots with today’s monetary policy statement. The question going into it was would the governor be more concerned about the weakening growth indicators or would he be more bothered by the upward trend in both core and headline inflation? The answer is now there for all to see – weak growth won the day," said Bank of New Zealand head of research Stephen Toplis.

According to Toplis, the central bank was "stridently dovish" and while he thinks it should contemplate normalising interest rates as soon as it gets the opportunity, "whatever the truth of the matter, we can’t ignore what the RBNZ is telling us and, to be fair, at least the messaging is relatively clear."

Toplis now expects the first rate increase in August 2019 versus a prior forecast of May.

Westpac's Stephens said, however, "while we agree that growth has passed its peak, we think that the RBNZ has actually overplayed the near-term softness angle. The RBNZ is expecting a 0.5 percent rise in June quarter GDP; our indicators put it closer to 1 percent ... the RBNZ may find that some of the downside risks to growth have dissipated by the time it comes to its next MPS."

Stephens still expects the central bank to remain on hold until late 2019.

The Reserve Bank was sanguine about signs of emerging inflation. To the contrary, Orr said there "are welcome early signs of core inflation rising. Inflation will increase towards 2 percent over the projection period as capacity pressures bite," he said.

Orr also downplayed any lasting impact from rising oil prices, the weaker kiwi dollar and wage increases saying the central bank would "look through this volatility as appropriate, and only respond to any persistent movements in inflation."

Bascand acknowledged the risk that recent wage pressure - due to government settlements with sectors like nurses as well as a lift in the minimum wage - could spill over and become more widespread. However, he underscored the key issue is whether or not firms can pass those increases onto consumers.

For now, the central bank isn't expecting a widespread spill over because imported goods, capacity constraints and competition from other domestic firms, making it difficult for firms to pass on any costs, he said.

"We have seen this for a considerable time. They talk about raising prices and then find that they can't," Bascand said.

Orr said the bank is confident in its central forecast, but acknowledged upside and downside risks, and the downside seemed to weigh more heavily on his mind.

While growth is expected to recover in our central projection "with surveyed business confidence falling and continued softness in the housing market, GDP growth may not recover as expected." That could lead to a 100 basis point rate cut, the central bank said.

On the flip side, firms’ price-setting behaviour is assumed to remain subdued. "However, increasing costs mean margins are being squeezed. There is a risk that firms could raise prices by more than we assume in response to these higher costs." In that scenario, rates could be 50 basis points higher, it said.

(BusinessDesk)

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