RBNZ October 23 OCR Preview: RBNZ to Cut 100bps

Daily Forex Fundamentals | Written by Westpac Institutional Bank | Oct 18 08 08:12 GMT |

To boldly go where no Governor has before The global situation is deteriorating rapidly. NZ will face tighter credit and weaker export prices and volumes. A large rate cut is clearly warranted. We think the RBNZ will favour a 100bp rate cut, as insurance against the risk of more bad news to come. The risks are skewed towards a smaller move, in order to rein in overcooked market expectations. Conditions have changed at a breathtaking pace since the September Monetary Policy Statement. Policymakers around the world are scrambling to restore stability and confidence in the financial system, but regardless of how successful they are, it's clear that the credit crunch will leave a sizeable dent in the real economy. Consensus forecasts for world growth in 2009 have been slashed from 2.8% to 2.1% in the last two months. While the RBNZ was already bracing for some downgrades to growth forecasts, the events of the past month will still come as a big shock to them. The timing is particularly unfortunate for New Zealand, as there were signs that the economy was picking up again after a recession in the first half of the year. With the drought well and truly over, fuel prices down, interest rates falling, and personal tax cuts kicking in from October, the outlook for growth in 2009 and beyond looked encouraging. But in market time, that's all ancient history. The economic case for delivering another large cut next week is clear. The only question is one of tactics - how much should they cut now to support domestic activity and maintain confidence, without stoking inflation, using up their ammo too quickly, or creating unrealistic expectations of more to come? There are at least three plausible options - 50bp, 75bp or 100bp - and on balance we see a 100bp move as the most likely, though we'd put the odds at no more than 50%. A 100bp cut would easily be the largest single change in the history of the OCR. Admittedly that overstates the significance of such a move, as it's only since 1999 that the policy rate has been set in discrete steps. You don't have to go back much further than that to find interest rate cycles that were more dramatic overall. The factors that we think will tip the RBNZ toward a 100bp cut are: The credit crunch has become much, much worse - but steps are being taken. Every new problem brings a fresh response from policymakers, so any forecast of when or how the crisis will end has to be highly conditional. Assuming that the Armageddon scenario is avoided, we can expect three lasting consequences that will affect every part of the world to varying degrees: tighter credit, weaker demand for exports, and lower commodity prices. New Zealand is in the unenviable position of being both a net borrower for consumption and highly dependent on commodity exports, so we are likely to suffer on all three fronts. These effects can be partly offset by a lower exchange rate - which is already the case - but more will be needed to soften the blow. Rate cuts as insurance. We were critical of the July and September rate cuts at the time, given that inflation is so high. But since then, the credit crunch has worsened and falling commodity prices have taken the sting out of inflation concerns, so the RBNZ won't have any cause for regret. The benefits of hindsight will also motivate next week's decision - a large rate cut would be a relatively cheap form of insurance against the likelihood of more financial nasties to come. If that insurance proves to be unnecessary, it can easily be reversed - as was the case with the rate cuts after 9/11. Interest rate passthrough. In both July and September the RBNZ expressed concern that OCR cuts may not be passed on fully - or at all - to retail interest rates, due to the rising cost of raising funds offshore. By and large, those fears haven't been realised, and mortgage rates for the most popular terms have been reduced by 75-90 basis points since July. Nonetheless, we suspect the RBNZ will proceed on the basis that any further passthrough is not guaranteed. The RBA cut by 100bp. While the RBNZ are in no way obligated to follow their neighbour, they will share many of the RBA's concerns. As well as the ‘passthrough' issue, which the RBA felt warranted “an unusually large movement in the cash rate”, they noted “a significant moderation in growth in Australia's trading partners in Asia”, and that “some decline in the [Australian] terms of trade now looks likely over the coming year”. The RBNZ have highlighted the growth outlook for Australia and Asia as particularly important for monetary policy, and they will respect the RBA's judgement on this matter. Inflation is off the radar for the moment. That's not the same thing as saying that inflation has been tamed, though. A halving in world oil prices, and sharp falls in other commodities, ensure that next year the annual rate of inflation will spend some time at the bottom of its 2-5% range, giving the RBNZ more room to front-load their easing. But on average, inflation is still expected to hold near the top of the target band - not least because the RBNZ has signalled that they intend to keep it there! The arguments for a move of less than 100bp are: Market expectations have run riot. It's not clear whether RBNZ Governor Bollard values the ‘announcement effect' of rate cuts - that is, by bringing wholesale rates down on the day of the OCR review, he can pressure lenders into passing this on to retail rates. But he would find it hard to achieve this time - expectations of rate cuts have been ratcheted up to the point that the market is now pricing in 120bp of easing for next week. A smaller cut may actually prove to be more helpful, by reining in market pricing and restoring the scope for surprises at future reviews. Dr Bollard could probably live with it if swap rates ended the day higher - they are already a further 50-90bp lower since the September MPS. The NZD has fallen sharply. The exchange rate has once again proven to be the New Zealand economy's first line of defence against global shocks, delivering a rapid easing in financial conditions. A weaker currency won't solve every problem, but equally it will reassure the RBNZ that they don't have to do all of the work themselves. Using the right tool for the job. New Zealand's banking system is in a very different position to the US or Europe: banks are still profitable and well capitalised, with high-quality assets. Their problem is the difficulty of accessing offshore funding - an issue that no policy rate cut, of any size, can fix (and at the margin could make worse by further discouraging investors). Liquidity problems are best dealt with using liquidity measures, a point that the RBNZ have themselves made in recent weeks. Implications Given the amount of easing that is already priced into interest rate markets, the RBNZ seems almost doomed to disappoint. Even so, the total change in wholesale rates since September should give lenders scope to reduce retail rates - in fact, Westpac has already lowered its fixed mortgage rates by 30-40bp. The implications for the currency are ambiguous, and in any case are likely to be swamped by other factors. As an indication, the RBA's 100bp cut earlier this month saw the Australian dollar first punished, then rewarded for such a proactive move - all in the space of a few minutes. Westpac Institutional Bank Disclaimer All customers please note that this information has been prepared without taking account of your objectives, financial situation or needs. 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