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The economists view on the OCR

Thursday 9th June 2011

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Headline: The economists view on the OCR

 

ASB's Nick Tuffley and Christina Leung

 

Growth outlook

The RBNZ's outlook for the economy has improved since the March Monetary Policy Statement, noting that the "negative confidence effect of the earthquake on economic activity throughout the rest of the country has been limited." The RBNZ notes firms expect to increase hiring and capital investment. The RBNZ expect that the caution shown by households will continue, and household expenditure is only forecast to grow modestly. High household debt is expected to continue to constrain retail spending. &These expectations are similar to our own forecasts.

 

The RBNZ forecasts reconstruction in Canterbury to "add about 2 percentage points to GDP growth over 2012, and boost the level of activity for several years thereafter". The pick up in construction activity forecast by the RBNZ is stronger than our own. Nonetheless, we think the inflationary impact of our more conservative (but still high) level of construction over the coming years will be greater than the RBNZ's forecasts suggest.

 

Tradable sector

NZ export commodity prices have remained strong, despite the global growth risks, which the RBNZ see as mainly negative at present. The strong NZD reflects the strength in key NZ export commodities. However, the Bank commented that although the substantial currency appreciation over the past two months is supported by high export prices for primary producers, the high NZD “is negatively affecting other parts of the tradable sector, constraining rebalancing of the New Zealand economy. We expect this challenge will continue, and our currency forecasts include a stronger outlook for the NZD compared to the RBNZ's latest forecasts. Despite the frustrations of a strong NZD, there was no hint of a desire for intervention in today's announcement.

 

Inflation

While the RBNZ acknowledges the recent jump in medium-term inflation expectations, it continues to expect annual CPI inflation will track around the midpoint of the target band of 2% "over the latter part of the projection." This expectation is based on the optimistic assumption that medium-term inflation expectations will start to trend down from current high levels of 3% over the coming year. Nonetheless, recent strong inflation indicators are starting to cause the RBNZ some discomfort. In a box highlighting the effects of reconstruction in the Canterbury region, the RBNZ notes its expectation "generalised pressure on prices will persist for several years". In particular, construction costs, rents and insurance premiums are highlighted as areas the RBNZ expects to see this upward pressure come through. We see upside risk to the RBNZ's inflation forecast given the extent of rebuilding required, with construction cost inflation expected to receive a strong boost later in 2012 as a result.

 

Implications

The RBNZ has become more comfortable that the wider economy is starting to pick up but less comfortable about the inflation outlook. Both of these factors raise the risk of an earlier tightening than we have previously thought. We have shifted our view of the first tightening to January, from March. We still view December through March as the more likely window.

 

The RBNZ's own interest rate forecasts now imply a first hike as early as December. That is where the risk lies. Signs of a brisk recovery would quickly reduce the need for the insurance cut put into place after the February earthquake. The RBNZ's nervousness about inflation expectations is another potential trigger of an early hike: if inflation expectations remain elevated between now and the November survey then a December hike would be very likely.

 

We still judge that the RBNZ has time to wait, and will need time to wait for certainty about recovery and reconstruction. Last year was a lesson about lifting interest rates too soon. And there is still far too much uncertainty about Christchurch's reconstruction for the RBNZ to have a clear picture of when inflation from that source will appear.That uncertainty is unlikely to be resolved sufficiently for a number of months. Importantly, we think the reconstruction risks being less rapid than the RBNZ assumes. If so, the RBNZ will likely rethink the monetary policy implications. Finally, the preponderance of floating mortgage rates and steep yield curve means monetary policy’s bite will be relatively swift and effective. That gives the RBNZ some leeway, and some comfort, should it become apparent that inflation is getting up a larger head of steam than currently forecast.

 

Our January call is later than the market is pricing in, for the above reasons. It comes conveniently after Q3 GDP signal the extent to which activity is growing once the initial earthquake disruption abates. December is the main risk to our call, if the recovery and reconstruction appear on track to meet RBNZ expectations. But any earlier than December is far too soon to resolve uncertainties about the reconstruction impact on inflation, or the persistent of the recent lift in inflation expectations. But once tightening starts, we expect the persistent nature of inflation drivers to prompt sustained OCR increases to 4.5%.

 

Market reaction

The market has moved to fully price a 0.25% rate hike from the RBNZ by the end of 2011, and expects rates to be around 3.75% based on December 2012 OIS prices. Two and three-year swap rates have also lifted around 9 basis points after the announcement. The NZD has lifted around 0.5c against the AUD and USD after the decision.

 

The OCR remained on hold at 2.5%, as widely expected. But the RBNZ's perceived risks to its previous outlook have shifted. The RBNZ has become more comfortable that the wider economy is starting to pick up but less comfortable about the inflation outlook. Both of these factors raise the risk of an earlier tightening than we have previously thought. We have shifted our view of the first tightening to January, from March. We still view December through March as the more likely window.

A December hike is a distinct risk, and is the timing implied by both the RBNZ's own interest rate forecasts and by market pricing of the future OCR.  But we still judge that the RBNZ has time to wait until early 2012, despite the discomfort over less favourable inflation developments. Even December could be too early to be fully confident recovery is firmly embedded and last year was a lesson about lifting interest rates too soon. There is still far too much uncertainty about Christchurch's reconstruction for the RBNZ to have a clear picture of when inflation from that source will appear. Finally, mortgage market trends give the RBNZ some leeway, and some comfort, should it become apparent that inflation is getting up a larger head of steam than currently forecast.

 

HSBC's Paul Bloxham

Six weeks have gone by and the Governor has shifted his tone from rates are on hold for 'some time', to rates are on hold 'for now.' What will another six weeks bring? The statement acknowledges continued recovery and that the negative effect of the quake on the rest of the economy outside Canterbury has been limited (themes we have built for a while). While noting the recent weaker global data, they also point out that commodity prices are very high, boosting the economy. The case is building for a reversal of emergency rate settings. We still expect the next hike in Q4, but the risk is for an earlier move.
Facts
- Cash rate held steady today at 2.50% (emergency lows).
- RBNZ has acknowledged that the negative effect of the Canterbury quake on economic activity outside that region has been limited.
- They expect GDP rose modestly through the first half of 2011, despite the quake.
- RBNZ forecasts GDP rose by 0.3% in Q1 and 0.4% in Q2 much like HSBC's forecasts for 0.3% in Q1 and 0.5% in Q2. We expect stronger growth in the second half though, for a 1.7% y-o-y rate versus RBNZ at 1.2% (an upward revision from 0.9%).
- RBNZ still expects a significant rise in GDP in 2012 (4.4% Q412/Q411) we do too.
- RBNZ inflation forecasts are largely unchanged, with CPI expected to be 4.5% in 2011 and 2.0% in 2012. We expect stronger inflation in the out year (3.0%).
- RBNZ noted the rise in inflation expectations, but is of the view that there remains significant excess capacity in the Kiwi economy that will keep underlying inflationary pressures at bay. We are less sure.
- The 90 bank bill profile underlying the forecasts is largely unchanged for this year (3.0% by Q4 2011) and revised up by 21bp for end 2012 to 4.55%. So they continue to imply a rate rise is likely by Q4 and now suggest around 175bps of hiking over the next 18 months – same as us.

Implications
The recovery is on and rates are still at emergency lows. What does this mean? Rates will need to rise and probably some time soon.

If the pace of change in the RBNZ Governor's rhetoric is anything to go by, emergency settings may be reversed sooner, rather than later. Six weeks ago he told us rates were on hold for 'some time', now it's 'for now'. Is the next step 'no longer'? Today's statement certainly firms up our view that rates will rise in Q4, and the risk is that it happens sooner.

But don't get ahead of yourselves. Last time the RBNZ was pre-emptive they regretted it. Today's statement virtually acknowledged as much. Second sentence of the overview tells us that at the time of the March statement "economic activity had undershot the Bank's forecasts for some time, and just as signs of recovery were emerging, Christchurch was struck by another devastating earthquake." So the RBNZ may be a little gun shy this time around.

The more medium-term outlook also sees a number of rate hikes, which should make for interesting times in 2012. RBNZ's underlying assumption for 90 day bank bills broadly aligns with our call for 175bps of tightening by Q4 2012.

RBNZ acknowledges the recent weaker global data but, very importantly, points out that the major channel for the world's effect on the Kiwi economy is through commodity prices which are at high levels. This is boosting incomes, investment spending and confidence.

The statement forecasts also show that the RBNZ does not expect any negative GDP results as a result of the Canterbury earthquake. Q1 is 0.3% and Q2 is 0.4%. It seems weakness in Canterbury is expected to be largely offset by strength elsewhere. This is a theme we have been running for quite some time (RBNZ Observer, 8 March 2011). In essence, about 5% of the Kiwi economy was severely affected by the February quake, the rest of the economy was already in recovery mode.

And of course the economy will get a boost from rebuilding. Such is the typical pattern observed following a negative supply shock. The RBNZ expects rebuilding in Canterbury to boost the economy by 2ppts in 2012.

An interesting medium term question will be whether a rate cut was the right response to a negative supply shock. It typically isn’t. The cost may be uncomfortably higher inflation.

Bottom Line
A bit more hawkish than the market expected.

Many of the themes are ones we have long been building – essentially that the Canterbury quake's effect would remain largely contained to that region. Particularly interesting that, like us, RBNZ has GDP forecast to rise in Q1 and Q2.

Still expect next rate rise in Q4, but the risk is for an earlier move. Also still have in mind rates rise 175bps by Q4 2012.

 

JPMorgan's Helen Kavens

RBNZ Governor, Alan Bollard, left the official cash rate (OCR) steady this morning, as was unanimously expected by all economists surveyed by Bloomberg. Having only just cut the key rate 50bp to a record low 2.5% in March as an insurance measure to mitigate against the adverse impacts of the recent earthquakes, there remained no urgency for Dr. Bollard today to reverse the move. That said, the Governor was more optimistic about the economy and less sanguine about the medium term outlook for core inflation, highlighting the risks of an earlier resumption of the tightening cycle than currently in our forecasts. As such, and having taking consideration of the recent string of better-than-expected economic data, we have made a modest adjustment to our rate call, with our forecast now calling for a March 2012 hike, rather than April.

Six weeks ago the RBNZ maintained that the current level of the OCR was likely to remain "appropriate for some time." Today, the OCR remains on hold "for now" and the pace and timing of the OCR hikes will continue to be guided by the recovery. Indeed, the resumption of the tightening cycle will be very much data-dependent. The Bank's forecasts are, though, more optimistic than our own, with the official forecasts signaling that GDP growth will accelerate markedly later this year, with the quarterly profile showing off a 1%-handle in the December quarter, and in the three quarters thereafter (as per the table below).

Indeed, Dr. Bollard appeared more confident in the post-earthquake recovery underway, and that the negative impacts of the earthquakes had been contained to the Canterbury region. The RBNZ's projections show GDP growth forecast at 2.5% in the March 2012 year and 4.6% in the March 2013 year. These forecasts compared to our own for growth of 2.3% and 4.4%, respectively, over the corresponding periods. Indeed, our forecast is for economic growth to accelerate throughout the year, but with output coming from an extremely low base, we maintain our view that it will take some time before the excess capacity in the economy is absorbed. Thus, we maintain that the resumption of the tightening cycle will be delayed until next year. By then, there should be conclusive evidence that the risks to the recovery from the recent quakes have well and truly abated, and underlying inflation no longer will be as benign. Headline inflation continues to be lifted by recent increases in indirect taxes, along with food and petrol prices.

RBNZ officials project that the reconstruction of Canterbury will add around 2%-points to GDP growth in 2012. The risk here is that there could be a boost to inflation from the earthquakes. The worry for the Bank will be the possibility that these price rises could lead to second round effects, particularly given that inflation expectations already are rising, as highlighted in today's statement.

The Governor also acknowledged the resilience of the external sector in the face of weakness in the global economy and higher NZD. Indeed, high NZD is among the biggest headwinds facing the economy. The significant appreciation of the currency had constrained the rebalancing of the economy towards exports. None theless, the external accounts have improved markedly, in particular the terms of trade, which now is at a 37-year high. Elevated commodity prices are softening the blow from the currency and were encouraging new hiring and capital investment. On the domestic front, owing to efforts by households to reduce debt, the household sector continued to underperform, and household expenditure is expected to grow only modestly, which will constrain retail spending and the housing market. Fiscal consolidation will also act to dampen activity.



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