The economists view on the OCR

Thursday 28th April 2011 1 Comment

ABS's Nick Tuffley

The RBNZ kept the OCR on hold. Although it seems more comfortable the economy will hold up in the wake of the earthquake, the high NZD and oil prices were seen as "unwelcome".

Growth: a little more confident

The RBNZ noted the drop in confidence following the earthquake, and the subsequent recovery in part buoyed by the cut in the OCR. While firms and households in Christchurch remain adversely affected, the RBNZ noted that the rest of the country seems relatively unaffected.This is an encouraging sign the remainder of the economy is holding up well despite the earthquake. Indeed, housing market activity (particularly in Auckland) and business investment has started to increase outside of Christchurch.

The RBNZ is also more upbeat on the rural sector, noting the increase in NZ export commodity prices, which along with favourable weather conditions has helped supported a pick-up in on-farm investment. This is a slight change from the March statement, in which the RBNZ noted that farmers had been focusing on repaying debt rather than spending. This is an area the RBNZ is likely to watch closely over the next year. A recent speech by the RBNZ warned higher export incomes may stimulate increased investment and borrowing activity, which may contribute to higher inflation pressures, which in turn the RBNZ would react to. Nonetheless, the NZ dollar is playing an important role in buffering the higher returns, although the RBNZ noted that the higher dollar was currently ‘unwelcome’ to the extent it is dampening economic activity. This suggests the RBNZ may also see US dollar weakness as a factor behind the high level of the NZ dollar, along with high commodity prices. High oil prices also remain a key risk to the growth outlook. Overall, the statement suggests the RBNZ may be slightly more confident in the economic recovery outside of Christchurch, although a large number of uncertainties remain.

Inflation: still very comfortable

The RBNZ remains comfortable with the inflation outlook, noting its expectations for annual inflation to fall back below the top of the target band of 3% once the tax increases drop out of the annual rate later this year. We continue to think the RBNZ is being too optimistic in its medium-term inflation forecast, given it relies on some weak CPI outcomes over the coming years in order for annual inflation to move back within the target band. While inflation indicators point to inflation pressures in the NZ economy being contained for now, we expect inflation pressures to re-emerge next year as post-earthquake reconstruction gets underway. Rebuilding activity over 2012 is likely to soak up excess capacity in the building sector and see a lift in underlying inflation.

Market reaction: overdone?

The NZD dropped 0.7c against the USD immediately after the statement. We see this as a bit of an over-reaction, given the decision to hold was unanimously expected, and the RBNZ language surrounding the level of the NZD does not suggest to us that intervention is on the cards. The RBNZ commented "higher oil prices and the elevated level of the New Zealand dollar are both unwelcome" as they "will have some dampening effect on economic activity." If they had chosen to describe the NZD as unjustifiably high, or listed some of the criteria for intervention, the currency drop would be more understandable.The interest rate reaction was a 5 basis point dip in yields, as the market focussed on the RBNZ's comfortable outlook on inflation, and statement that "the current level of the OCR is likely to remain appropriate for some time."

Implications

The statement doesn't give any further clues as to when the RBNZ will begin to lift interest rates. The comments were mixed. The RBNZ does see little chance of the wider economy getting pulled down by the earthquake, with some tentative signs of pick-up since the March OCR cut and commodity prices till favourable. However, oil prices and the high NZD have potential to dampen the economy to a greater extent than the RBNZ would have factored in back in March.

The weakness in the NZD after the statement appears an over-reaction to the "unwelcome" level of the NZD. Despite that reference, it is unlikely the RBNZ will intervene to try and blunt the NZD.With commodity prices firm and the USD on the back foot, intervention is unlikely to be effective and current circumstances don't meet the RBNZ's criteria for acting.

We continue to expect that the RBNZ will refrain from lifting the OCR until March 2012. Timing will be heavily influenced by when earthquake reconstruction picks up steam, but the most likely window is December – March. Market pricing is erring on the early end of that window.

Westpac

OCR unchanged at 2.5%, RBNZ issues firmly "on hold" statement

The RBNZ's press release gave little guidance on the timing of future OCR changes, noting only that "the current level of the OCR is likely to remain appropriate for some time." This amounts to a fairly "straight bat" approach, maintaining the status quo. We continue to expect the RBNZ will move to hike the OCR only once reconstruction work in Christchurch is firmly under way - most likely next year.

The assessment of recent economic developments was upbeat. The RBNZ mentioned that nationwide economic activity had held up despite the Christchurch earthquake, trading partner growth has remained robust, and export commodity prices had pushed higher.

But despite the improved economic picture, the Reserve Bank is very comfortable with the inflation outlook. Headline inflation is expected to settle comfortably within the target band once tax increases drop out of the annual rate. The Bank also noted that the high level of the New Zealand dollar was "unwelcome", and would have some dampening effect on economic activity.

Market implications
Before today markets were becoming increasingly interested in the idea of OCR hikes this year. Today's OCR review failed to vindicate that view. Consequently, markets interpreted the statement as relatively dovish. The NZD fell half a cent and 2-year swap rate fell 6 basis points. However, markets are still pricing a 60% chance of an OCR hike by December this year. We think that is too high.

We continue to expect the RBNZ will hike the OCR only next year. Yes, the economy is holding up surprisingly well. But the economy is currently operating well below its productive capacity. There is ample room to grow before encountering inflationary speed limits. And the strong exchange rate will continue to dampen inflation for some time. The main threat to inflation - bottle-necks associated with Christchurch reconstruction - is unlikely to arise before 2012.

Once the hiking cycle is underway, however, we expect it could be steeper and more prolonged that markets are currently anticipating.

JPMorgan's Helen Kevans

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 was no immediate pressure on Dr. Bollard today to reverse the move; there will not be any such pressure in the near term. Indeed, the Governor made clear today that given the outlook for core inflation and continued economic disruption stemming from the earthquakes, the current level of the OCR is likely to remain appropriate for some time.

The neutral statement implied the RBNZ has adopted a 'wait and see' approach. Thus, we maintain our forecast for the cash rate to stay at the current record low until 2Q12. By then, there should be conclusive evidence that the earthquake reconstruction phase is in full-swing, that the domestic economy is standing on its own two feet, and that above trend growth (as of 1Q12 on our forecast) will be reducing the excess capacity in the economy.

In the very short statement that accompanied the OCR announcement this morning, the Governor said that the outlook for the New Zealand economy remained "very uncertain" following the earthquake in Christchurch (Feb. 22). In the wake of the tremors, indicators of confidence, spending, and tourism had declined sharply, although had since shown signs of recovery. That said, the RBNZ highlighted that activity outside Christchurch appeared "relatively unaffected". Indeed, on a positive note, with respect to the broader economy, the RBNZ acknowledged that housing market turnover and business investment had begun to increase, that trading partner growth remained robust, and commodity prices high. On the other hand, however, higher oil prices and elevated NZD were having a dampening effect on activity.

Our forecast is for economic growth to accelerate gradually throughout the year, although growth will be coming from an extremely low base, meaning that it will take some time before the excess capacity in the economy is absorbed. Indeed, even prior to the February earthquake, the economy had underperformed, mainly owing to efforts by households to reduce debt. While there had been some signs that the economy was beginning to recover early in 2011, these were more than offset by the Christchurch earthquake; post-quake, the economy likely will have contracted in 1Q.

The Governor appeared comfortable with the inflation outlook. Although at present "headline inflation is currently being boosted by recent increases in indirect taxes", the RBNZ expects that annual inflation will “settle comfortably within the target band” of 1%-3% once these tax increases drop out of the annual rate. This should be in 4Q11 but, until then, the RBNZ will be concerned that higher headline inflation (currently at an elevated 4.5%oya) could influence price- and wage-setting behaviour.

Indeed, the RBNZ already has acknowledged 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. The main risks, therefore, is that higher prices could start to flow through into higher inflation expectations. The RBNZ would then be forced to remove the current stimulus sooner than we now predict. For now, though, core inflation remains benign and inflation expectations anchored. Providing this remains the case, we believe the RBNZ will remain comfortably sidelined throughout 2011.

HSBC's Paul Bloxham

The RBNZ left the OCR unchanged at 2.50%, as expected, with the Governor indicating that he expected to hold steady for 'sometime'. He noted some signs of recovery, particularly in farm investment and the housing market, and that recent weakness has been largely contained to quake-affected Christchurch. The RBNZ seems unconcerned about the inflation outlook but expressed some concern about high oil prices and the high NZD. We still expect economic conditions to warrant a rate rise before year-end.

Facts

- The Governor said, 'confidence and consumer spending have shown signs of recovery, but many firms and households remain adversely affected in Christchurch. To date, activity in the rest of the country appears relatively unaffected, with housing market turnover and business investment beginning to increase.'
- He also said that 'along with relatively favourable climatic conditions, the improved [commodity] price outlook is supporting a pickup in on-farm investment.'
- He noted that 'higher oil prices and the elevated level of the New Zealand dollar are both unwelcome,' and that 'they will have some dampening effect on economic activity'.
- Finally, 'given the outlook for core inflation, [to return comfortably within the target band], and continued economic disruption stemming from the earthquakes, the current level of the OCR is likely to remain appropriate for some time.'

Implications

As always, the post-decision statement was short, so there is little gristle to chew on. The main gist of the statement was largely as expected and does not change our view that the next rate rise is likely to be in Q4. From the RBNZ's perspective there is no need to hint at the timing of the next rate rise, as it is widely understood to be some time away.
One area that differed from our expectation was just how sanguine the RBNZ seems about the outlook for inflation. The Governor did mention some concerns about oil prices, but also pointed out that the OCR level was appropriate because the outlook for 'core' inflation was for a return to target. They seem content to attribute the current high level of CPI inflation (0.8% q-o-q and 4.5% y-o-y) entirely to the effect of last year's tax changes.

Another area of interest was the Governor's concern about the high level of the NZD. The exchange rate is currently at a high level against the USD, trading around 81 cents, though on a trade-weighted basis it is still below its highs of 2010, which is an indication of the extent to which it reflects USD weakness rather than NZD strength. Nonetheless, the Governor's comments are likely to fuel further debate about the level at which the RBNZ might become uncomfortable with the exchange rate, and their appetite to intervene.

Bottom Line

The OCR was left unchanged at 2.50%. The post-decision statement had few surprises and suggested little about the timing of a return of rates towards normal. We still expect economic conditions to warrant a rate rise in Q4.

NAB Capital's Yvonne Liew

While we're not nearly as relaxed about inflation as the Bank obviously is, at least the Bank has maintained a thread of consistency from the super-conservative tack it took in March. Even if our central bankers quietly confessed the economy has held up better than they thought it would, post the quake, and that inflation needs some watching, they were hardly going to say so publicly at this stage of proceedings.

Comments from our readers

On 28 April 2011 at 1:10 pm Christopher said:

Aww gee that must have been a difficult conclusion for them to arrive at.