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No change on Wednesday but is the OCR headed up, down or sideways?

Monday 11th February 2019

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Reserve Bank governor Adrian Orr will probably acknowledge the increasing storm clouds on the horizon globally but nobody is expecting him to make any change to interest rate settings on Wednesday when he releases the latest monetary policy statement.

All the attention will be on the tone of the statement and on any changes to the language from the last statement in November. Back then Orr expected to keep the official cash rate, at a record low 1.75 percent since November 2016, unchanged into 2020.

The market will also be watching for any changes to the each-way bet Orr took in November as to which direction he will next move the OCR.

All of the 18 banks and merchant banks Bloomberg surveyed expect no change to the OCR until late this year at the earliest.

Mark Lister, the head of wealth research at Craigs Investment Partners, says little has changed much since November – inflation has been slightly stronger but economic growth a little weaker than expectations and dairy prices have been stronger in the recent Global Dairy Trade auctions.

The big change has been in the abrupt bearish turns from Federal Reserve chair Jerome Powell and Reserve Bank of Australia governor Philip Lowe and the worsening outlook for global growth, particularly in China and Europe.

Last week, Lowe delivered an OCR decision using language the market took as encouraging and the Australian dollar rallied. Later in the week, Lowe indicated the market's interpretation was incorrect and that the outlook for Australia's economy is so uncertain that he may have to cut his OCR from its current 1.5 percent record low.

Powell has gone from promising to raise the Fed's cash rate three more times this year last October, to two likely hikes this year in December. He is now promising to be “patient,” with his increasing caution, fuelled by signs of slowing growth in the United States and the trade tensions between the US and China.

“If the Fed's no longer hiking, then that suggests that other central banks around the world have to re-think their forecasts as well,” a kind of “re-basing” effect, Lister says.

He's expecting Orr will still want to hedge his bets: “There have been some genuine indications that growth has tapered off a little but there are still a lot of 'what ifs' out there.”

Financial markets are pricing in a 42 percent chance of an OCR cut by the end of June and a 100 percent chance of a cut within the next 12 months.

As yet, only one banking house in Bloomberg's survey shares the market's view, ANZ Bank. Chief economist Sharon Zollner says the economy “is clearly coming off the boil. Trading partner growth is slowing markedly. We are forecasting an OCR cut by year-end, whether the Reserve Bank changes their growth and OCR forecasts meaningfully or not.”

Zollner is far from alone in noting the economy has been slowing, but she clearly isn't expecting the pick up in activity others are predicting.

“The potential growth risks are accumulating," she says. "The potential growth impacts of a more marked global slowdown are now a more pertinent risk than any delayed impact from last year's slump in business confidence,” she says.

Nevertheless, there are upside risks to inflation – that's still the Reserve Bank's key mission, tempered by needing to try to promote maximum sustainable employment.

While figures last week showed the unemployment rate jumped to 4.3 percent in the December quarter from a revised 4 percent in the September quarter, the labour market remains very tight, although there are few signs of wage inflation yet.

Zollner notes that firms are reporting sharply higher costs but very modest pricing intentions and “something has to give – pricing intentions and costs don't tend to move in opposite directions for long."

Bloomberg's survey shows ANZ is expecting more than one OCR cut. It expects it to go to 1.5 percent in the fourth quarter this year and to 1 percent in the first quarter next year.

ASB Bank is expecting the OCR to remain where it is through the second quarter of next year but others, such as Bank of New Zealand, are still expecting an OCR hike to 2 percent in the December quarter this year, followed by a second hike to 2.25 percent in the March quarter of next year.

Jane Turner, an economist at ASB Bank, says she expects Orr will acknowledge the increasing downside risks to the economic outlook but she expects that will probably prove temporary.

She also says that rising inflation pressures will mean the need for higher interest rates in coming years.

But she thinks those higher rates will be delivered by the Reserve Bank's requirement that banks must hold more capital in future to reduce the risk of bank failure.

The central bank's current proposal, which is currently out for consultation, is that the 'big four' banks will have to about double their equity capital.

“Our key message is that we continue to expect borrowing rates to rise gradually in coming years. However, a significant part of this increase is now likely to come through increased bank funding costs with the OCR to do less of the lifting.”

BNZ head of research Stephen Toplis says his bank may well change its OCR forecast, delaying an expected rate hike until 2020.

He points out that while the jump in the December unemployment rate surprised the market, it still came in a notch below the Reserve Bank's 4.4 percent forecast.

“Surely, the Reserve Bank must now sit on its hands when it releases its February MPS next Wednesday. We see little justification for a shift to either a more, or less, aggressive stance than it held in November and we see significant justification for the bank to buy itself more time,” Toplis says.

With changes to the central bank's structure – it is about to move from the governor having sole responsibility for monetary policy to a committee structure – there is an ongoing review of the Reserve Bank and there are other changes planned on the prudential front.

“The Reserve Bank governor currently has more pressing issues to contend with than fiddling with interest rates,” Toplis says.

Given the Reserve Bank's dual mandate of price stability and maximum sustainable employment, “it seems to us that both are being achieved. If anything, inflation is slightly shy of its target but the unemployment rate, and other job shortage indicators, caution that the current tightness in the labour market might be beyond sustainable.”


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