RBNZ September MPS Preview: OCR to be cut 25bp to 7.75%

Daily Forex Fundamentals | Written by Westpac Institutional Bank | Sep 07 08 12:30 GMT |

Taking it to the limit The RBNZ will deliver the 25bp that the market expects, avoiding the risk of a de facto tightening. High oil prices are a tax on growth, so the recent fall in world prices - even if it wasn't cancelled out by the weaker currency - is not as disinflationary as it might seem. Inflation is likely to test the most generous interpretation of the RBNZ's target. A lot has changed since the June Monetary Policy Statement. And there has been one big change in particular: after taking great pains in June to signal a cautious approach to easing, the Reserve Bank cut the OCR in July and left the door wide open for further cuts over the rest of the year. What appears to have tipped the balance in July was a fear that higher funding costs, due to the global squeeze in credit markets, would lead to a de facto tightening in the absence of an official rate cut. Those fears didn't quite pan out - in fact the most popular fixed-term mortgage rates were actually cut in line with the drop in the OCR. But the RBNZ faces a similar issue this time: current market interest rates are predicated on a series of OCR cuts over the rest of this year, so a pause at this stage could send rates higher again. As a result, next week's decision looks relatively straightforward for the RBNZ: deliver the 25bp cut that the market is pricing in. The more difficult question is how the RBNZ proceeds from there. The domestic economy appears to be bottoming out, albeit at a lower level than expected. The RBNZ is counting on softer activity to reduce the pressure on inflation over the next few years, but they don't have a lot of room for error. As usual, in our discussion below we consider the key developments since June in terms of what they mean for inflation. Inflationary developments Lower NZD: The RBNZ's comment in July that further rate cuts are likely on the condition that “there is no excessive exchange rate depreciation” was like a red rag to a bull for markets. The NZD has plunged more than 10% against the USD since then, fuelled by expectations of lower interest rates here and in Australia, concerns about the slowing global economy, and liquidation by Asian retail investors. The trade-weighted index is currently tracking about 4% below the RBNZ's projections, which will add to near-term inflation pressures. Oil prices: Calling oil an inflationary risk may seem odd when crude prices are more than 25% off their peak, but bear with us. In June, the RBNZ assumed that the Dubai crude price would average US$117 per barrel over the September quarter. Since then, it has been as high as $141 and as low as $103, but the average so far this quarter has been $121 (Figure 1). So despite the recent volatility in prices, oil is no lower than the RBNZ expected in US dollar terms - and certainly higher in NZD terms. Even if the fall in world oil prices continues, cheaper fuel is not as disinflationary as it might seem. The New Zealand economy, like the rest of the world, has suffered a major cost shock as well as a slowdown in demand. The speed of the rise in fuel prices has severely curtailed households' purchasing power, and businesses haven't been able to fully pass on the increase in costs. So it follows that a reversal of the oil 'shock' could see activity bounce back much faster than the market expects. Petrol below $2/litre is something to cheer about only in a relative sense, but the impact is already showing up in surveys of consumer and business confidence. Strictly speaking, the RBNZ's forecasting model is neutral on oil, as lower prices reduce inflation in the near term but stronger activity adds to inflation further down the track. But the RBNZ is already counting on weak growth to take care of inflation for them over the medium term, so a sudden return to growth would be inconvenient from their point of view. Higher inflation peak: In June the RBNZ expected annual inflation to peak in the September quarter at 4.7%; in the July statement this was revised up to “about 5%”. Even with the fall in oil prices, we think their September forecast will still be around 5% - the upside surprise to the June CPI will have added 0.2% to their forecast, and the weaker currency has eroded most of the benefit of lower world oil prices. As always, the RBNZ has the ability to look through a nearterm inflation spike, but they need to address the second-round effects of higher inflation expectations. And that's where the problem lies: years of above-target inflation outcomes have seen expectations creep all the way up to the top of the 1-3% target range (Figure 2). The RBNZ has made a judgement that the passthrough from actual to expected inflation will be less than usual, due to the weaker growth picture. But they are taking a big risk if that judgement turns out to be wrong. Labour market: Employment rose by 1.2% in the June quarter, reversing a 1.3% drop in the March quarter. The fall in Q1 had always looked strange at this stage of the cycle, and the RBNZ seems to have treated only half of it as genuine. But they would have been wary of the risk that the jobs market had turned much faster than usual. The latest figures have removed that risk - while employment was effectively flat in the first half of this year, it has been an orderly slowdown rather than the catastrophic one that the Q1 figures implied. Meanwhile, wage pressures have actually intensified. The June quarter Labour Cost Index record a 3.5% annual rise in wages, the fastest pace in the history of the series. The details showed that an increasing number of workers have been able to secure cost-of-living adjustments, and anecdotes suggest that skilled workers are successfully negotiating even more on top of that. Disinflationary developments GDP lower: In June the RBNZ expected GDP to grow 0.2% in Q2, following a 0.3% drop in Q1. But all of the indicators since then have suggested that Q2 was at least as tough as Q1 - we now expect the RBNZ to match our forecast of -0.5%. While this is 'history' in a sense, it means a lower starting point for activity than previously thought, and therefore less inflation pressure over the medium term. World growth weaker: Consensus forecasts for growth in New Zealand's major trading partners have been revised down further - especially for Australia, which the RBNZ has singled out in recent statements as a key pillar of support for New Zealand. The latest forecasts for world growth for calendar years 2008 and 2009 stand at 2.9% and 2.7% respectively, compared to 3.0% and 3.1% at the time of the June MPS. On top of this, markets are becoming more nervous about the prospect of a rapid slowdown in Asia. It's not clear if these economies are genuinely coming unstuck, or are just moderating after unsustainably rapid growth in recent years. The importance of this channel is difficult to judge. As in New Zealand, much of the slowdown in global growth can be traced to the food and energy price 'shock' hitting consumers and businesses. Indeed, Consensus forecasts of world inflation have been revised upward massively since June. We don't have a sense of how much influence this will have on the RBNZ's forecasts - it's simply never been an issue before. Weaker global growth may not reduce NZ inflation, if that weaker growth has been caused by inflation. Credit crunch: Global credit markets have shown no signs of improvement in recent months, and the premium paid for offshore funding remains unusually high. The RBNZ's data, as originally published in July, suggested that banks' average funding costs had risen an alarming 20bp in the space of two months, independently of any official rate changes (Figure 3). The data also indicated that lending margins had been squeezed to record lows, implying that lenders had yet to pass on the latest increase in funding costs. But here the plot thickens. The corrected figures published in August tell a different story: the sharp rise in the cost of funding has been virtually revised away! Funding costs have certainly risen since the credit crunch began last year, but there has been no real deterioration since January - ditto for lending margins. So this raises an intriguing question: did Dr Bollard get a bum steer in July? Forecast details The RBNZ's growth forecasts for this year will be weaker than in the June MPS, mostly due to the shortfall in Q2 growth. Consumers were already projected to be flat on their backs for several years, and that's where the RBNZ wants them to be in order to ease domestic inflation pressures. If anything, growth forecasts for 2009 and beyond could be a touch higher. Despite the weaker near-term growth outlook, the inflation profile could be at least as high as in June. The RBNZ doesn't have much wiggle room around the upper edge of their inflation target, but recent comments suggest that they intend to use it all. Their June projections had inflation remaining above 3% until 2010, and only reaching 2.6% by the end of their forecast window three years ahead - a margin that they described as “comfortable” (Figure 4). But the July statement dropped the word “comfortable”, and in a radio interview Dr Bollard said that he expected to “only just” meet his inflation target. Admittedly these statements were made when oil was closer to $130 a barrel, but there's no reason why oil prices today should have any bearing on inflation forecasts three years ahead. It seems instead that the RBNZ has decided to stretch their definition of price stability to its very limit, in order to deliver rate cuts now. It's worth noting that some of the RBNZ's previous inflation bugbears are starting to rear their heads again. Recent signs are that the costs of the Emissions Trading Scheme may be substantially higher than the RBNZ has budgeted for, and there are indications of even more fiscal slippage after the election later this year. All up, this points to a significant change to the 90-day rate projections. The June MPS implied a gradual pace of easing, no more than one cut every quarter at first, with more in the later years once the RBNZ could be more confident that inflation was returning to the target band. But the fact that they have already started cutting means that the timing of the easing cycle will need to be brought well forward. We estimate that the developments since June are worth an additional 25bp of easing in the RBNZ's forecasting model - and this was already delivered in July. The 90-day rate projections will be revised to incorporate an earlier easing cycle, but not necessarily a deeper one. Summary We expect the RBNZ will broadly endorse market expectations of further rate cuts this year, without committing themselves to cuts at every review. We don't think that the condition of “no excessive exchange rate depreciation” has been breached yet - though if the currency continues to fall at its recent pace, a pause at the October or December reviews is certainly on the cards. The RBNZ still faces a difficult balance between slow growth and high inflation - and markets clearly have no intention of making life easier for them. We don't share the RBNZ's confidence that softer growth will take care of the inflation problem, and as signs of growth start to emerge going into 2009 - it will be grumpy growth, with some sectors benefiting far earlier than others, but growth nevertheless - the RBNZ is going to have to return to tackling inflation head-on. We still expect the OCR to be reduced to 7.00% by early next year, a much higher 'trough' than in previous easing cycles. Westpac Institutional Bank Disclaimer All customers please note that this information has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs. Australian customers can obtain Westpac's financial services guide by calling +612 9284 8372, visiting www.westpac.com.au or visiting any Westpac Branch. 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