Reserve Bank leaves Official Cash Rate unchanged at 5.5% but warns if inflation proves stronger than expected it may have to hike the OCR again

The Reserve Bank (RBNZ) has again left the Official Cash Rate (OCR) unchanged on 5.5%, but is warning that if inflation proves stronger than expected it may have to raise rates again in future.

The statement from the RBNZ Governor Adrian Orr was much more 'hawkish' than expected and seems aimed firmly at dampening down speculation that interest rates may soon be falling. The RBNZ is clearly becoming concerned about the potential impact of surging inbound migration and makes numerous references to this in both the media statements and the November Monetary Policy Statement.

All eyes on Wednesday were always going to be on the 'forward track' forecast the RBNZ has for the possible future level of the OCR - and it is here that the RBNZ has thrown in a big surprise.

It is now forecasting a peak OCR of 5.69% in the September quarter of 2024. Effectively this means the RBNZ sees a fair chance of another hike. This will come as a 'hawkish' surprise for a market that has already been factoring in OCR falls next year.

Indeed there was a swift market reaction. The NZ dollar immediately rose by about half a cent to US62c, although then started to weaken again a little.

Wholesale interest rate markets have been 'pricing in' a first cut to the OCR by August of next year and as of earlier on Wednesday before the OCR announcement were pricing in three cuts by early 2025.

Therefore wholesale interest rates reacted sharply, with the two-year swap rate, for example rising by 12 basis points to 5.25%.

Westpac chief economist Kelly Eckhold said the most notable changes in the press statement and meeting record was increased concern that inflation would remain persistent with upside risks from upwardly revised forecasts.

"A key driver is increased concern that migration and population would drive increased demand and medium-term inflation pressures. The RBNZ’s forecast for house prices was revised up from 4.3% to 5.5% for 2024 reflecting these pressures."

Eckhold said the statement of record also noted that government investment looks set to be stronger in line with pre-election forecasts, which also adds to medium term demand concerns.  

"Our overall first impression is that the RBNZ is concerned that further increases in interest rates may be required towards the middle of 2024. Key will be migration and housing market indicators over the next few months and the next couple of CPI [inflation] outturns. The new government’s fiscal projections in the HYEFU [half-year economic and fiscal update] before Christmas will also be a key focus."

"OCR cuts certainly do not seem to be on the radar for the RBNZ right now," Eckhold said.    

Recent economic data have started to move in the RBNZ's favour. The annual inflation rate as measured by the Consumers Price Index (CPI) was at 5.6% as of the September quarter, down from 6.0% in June 2023 and a peak of 7.3% in June 2022, while the previously super hot labour market is now cooling, with unemployment rising to 3.9% as of the September quarter, up from 3.6% in June and the low point of 3.2% in September 2022.

It's the fourth consecutive 'on hold' decision from the RBNZ since the central bank indicated in May it was done with raising rates, at least in the foreseeable future.

But the RBNZ is clearly not convinced it has everything under control.

The RBNZ, remember, is charged with keeping inflation within a 1% to 3% range and with an explicit target of 2%. The actual inflation rate has been outside the target range since the June quarter in 2021. The RBNZ is still, in its latest forecasts, picking that inflation will return back under 3% in the September quarter of next year. That's unchanged from the previous forecasts.

Among the many mentions of inbound migration in the Monetary Policy Statement, the RBNZ says that high net immigration has alleviated acute labour shortages caused by tight border restrictions during the Covid-19 period.

"However, there are signs that a stronger demand impulse from high population growth is emerging, contributing to an upward revision of our outlook for capacity pressure."

The RBNZ also notes that "in recent months, high net immigration appears to have put more pressure on rental price growth".

In the summary of the meeting of the RBNZ's Monetary Policy Committee, the RBNZ says that in discussing the appropriate stance of monetary policy, members agreed they remain confident that monetary policy is restricting demand.

"Nevertheless, ongoing excess demand and inflationary pressures were of concern, given high core inflation."

"Members discussed the possibility of the need for increases to the OCR. Members agreed that with interest rates already restrictive, it was appropriate to wait for further data and information to observe the speed and extent of easing in capacity pressures in the economy." 

"The Committee agreed that interest rates will need to remain at a restrictive level for longer, to ensure annual consumer price inflation returns to the 1% to 3% target range and to support maximum sustainable employment."

This is the statement from the Reserve Bank:

Interest rates are restricting spending in the economy and consumer price inflation is declining, as is necessary to meet the Committee’s Remit. However, inflation remains too high, and the Committee remains wary of ongoing inflationary pressures. 

Internationally, economic growth has been stronger than was expected at the start of this year but remains below trend and is likely to slow further. This subdued growth outlook will continue to restrain New Zealand’s export revenues. 

In New Zealand, demand growth has eased, but by less than anticipated over the first half of 2023 in part due to strong population growth. The OCR will need to stay restrictive, so demand growth remains subdued, and inflation returns to the 1 to 3 percent target range. 

Wage growth has eased from recent peaks. Demand for labour is softening, with job advertisements now below pre-COVID-19 levels. At the same time, strong inward migration is increasing the population and adding to labour supply. 

While population growth has eased supply constraints, the effects on aggregate demand are becoming apparent. This is increasing the risk of inflation remaining above target. 

The Committee is confident that the current level of the OCR is restricting demand. However, ongoing excess demand and inflationary pressures are of concern, given the elevated level of core inflation. If inflationary pressures were to be stronger than anticipated, the OCR would likely need to increase further. 

The Monetary Policy Committee agreed that interest rates will need to remain at a restrictive level for a sustained period of time, so that consumer price inflation returns to target and to support maximum sustainable employment.

Summary of Monetary Policy Committee meeting:

The Monetary Policy Committee discussed recent developments in the New Zealand economy. The Committee agreed that monetary conditions are restricting spending and reducing inflationary pressure. Supply constraints in the economy continue to ease and demand growth is slowing, but to a lesser extent than expected. Inflation remains too high and inflationary pressures continue to emerge. Further slowing in spending growth is needed to reduce demand toward the economy’s ability to supply goods and services, to ensure that consumer price inflation returns to its target range. 

Global economic growth remains below trend as high interest rates weigh on demand. Easing global demand is placing downward pressure on New Zealand exports, and export revenues are lower than in recent years. However, global prices for some products, such as dairy, have stabilised in recent months. Members noted that to date, global growth has been stronger than was expected at the start of this year, supported by sustained strength in the US economy and a recent lift in economic activity in China. However, going forward, subdued global growth is expected to restrain demand and prices for New Zealand’s exports over the medium term. 

The Committee discussed international inflation trends. Globally, headline inflation continues to fall, but there are differences in both the timing and magnitude of these declines across countries. Housing rent inflation is an important source of difference in services inflation across countries, with greater upward pressure in economies experiencing high net immigration, such as New Zealand and Australia. 

In discussing global financial conditions, the Committee noted that long-term interest rates for government debt have increased, largely in response to the rising volume of public debt. More recently, interest rates have decreased as financial markets anticipate the end of the phase of monetary policy tightening by major central banks. Members also noted that most major central banks have indicated that they intend to retain current restrictive policy rates for longer, and are willing to tighten further, if required. 

The Committee discussed recent domestic economic developments. While growth in parts of the economy is slowing, there has been less of a decline in aggregate demand growth than expected earlier in the year. As was noted in the October Review, GDP growth in the second quarter of 2023 was higher than expected while growth in the first quarter was revised up. Consumer spending growth is broadly easing, but some areas of services spending remain more resilient. On an aggregate level, consumption is being supported by the strong growth in population, whereas on a per capita basis, consumption is declining.

Members noted that net immigration has been higher than previously assumed. This has increased the supply of workers into a tight labour market. However, the demand-side effects are becoming apparent. Strong population growth has contributed to an increase in housing rents. Rent increases, and any increases in construction costs in response to greater housing requirements, affect inflation directly, as rental prices and construction costs are accounted for in the consumer price index. Members noted that the outlook for residential investment was currently muted, despite the surge in population growth. 

House prices have stabilised after earlier declines, with strong population growth and increased nominal disposable incomes offsetting the effect of higher debt servicing costs. House price increases affect inflationary pressures indirectly, via higher household wealth and an associated increase in consumption. Some members considered that the willingness of households to consume out of wealth may be lower given recent house price falls, higher debt servicing costs, and a softening labour market. Other members considered that there may be upside risks to house prices, and therefore consumption, given the anticipated decline in residential investment. 

Annual headline inflation was lower than expected in the September 2023 quarter. This was accounted for by lower inflation for tradable goods and services. Members noted that tradable inflation can be volatile and cannot be relied upon to achieve their inflation target. Non-tradable inflation is easing only gradually and, while all measures of core inflation have declined, they are still elevated. Short-term inflation expectations have declined, and members expect this to continue as headline inflation moves lower. Some members were concerned that 2-year inflation expectations were not declining particularly quickly and that longer-term inflation expectations had also increased. Other members were less concerned as they viewed longer-term inflation expectations as still close to the target midpoint.

In discussing the labour market, members noted that the underutilisation rate and unemployment rate both increased in the September 2023 quarter. Population growth has increased labour supply, as seen in declines in surveyed measures of labour shortages. As economic activity slows, labour demand is also declining, with job advertisements falling to below pre-COVID-19 levels. Wage inflation has eased. Members noted that whilst pressures in the labour market are easing, it is still tight, and employment remains above its maximum sustainable level. 

At the time of the October Review, members had noted updates in the Pre-election Economic and Fiscal Update 2023 (PREFU). Specifically, while total government spending as a share of potential GDP is still forecast to decline, this was now by less than previously expected. The PREFU included a material increase in government investment over the medium term, linked to infrastructure requirements. 

Members agreed that population growth and government investment would both likely support aggregate supply in the economy. However, they noted that in the short to medium term, demand could only sustainably grow at the economy’s production potential without adding to inflationary pressure. The current context is that aggregate demand has been greater than the economy’s ability to supply goods and services, creating inflationary pressure. While the economy is moving back into balance, ensuring that demand remains contained will make the task of returning inflation to target much easier.

The Committee noted that the estimate of the long-run nominal neutral OCR has increased by 25 basis points to 2.50 pecrent within the economic projections, consistent with the Reserve Bank’s indicator suite. The long-run nominal neutral rate impacts the central economic projections but has a larger impact in the latter part of the forecast horizon and beyond. Members agreed that the current level of the OCR remains contractionary.

The Committee discussed domestic financial conditions. Credit demand remains subdued as higher interest rates and a slowing economy reduce the ability and willingness of businesses and households to borrow. Mortgage rates have continued to increase, as expected. Members noted that the average rate on outstanding mortgages is expected to increase from 5.4 percent currently to 6.4 percent by mid-2024. The share of disposable income going to debt servicing for households with a mortgage is expected to increase from 15 percent currently to 19 percent.

The Committee discussed the expected evolution of retail interest rates, given ongoing changes in bank funding. Term deposit rates and volumes have increased. Higher term deposit rates are now contributing to ongoing increases in mortgage rates. As competition for term deposits continues, the margin between mortgage rates and wholesale interest rates is expected to return to more historically normal levels. Members agreed this expectation was consistent both with their previous discussions around future changes to retail interest rates, and with assumptions in the economic projection.

The Committee discussed the balance of risks for inflation, output, and employment. Members agreed that while the risk profile remained broadly similar to that discussed at the time of the August Statement, some of the short-term upside risks to activity appear to have eventuated and have therefore been incorporated in the central economic projection. In considering risks, members also specifically discussed two scenarios.

The first scenario was one of persistent domestic demand strength supported by strong population growth, with increases in rents and aggregate consumption feeding into greater inflationary pressure and higher house prices. The second scenario considered a larger global economic slowdown, with growth below trend for longer than currently anticipated. A greater slowdown in global growth would see a fall in the price of imports and further reduce goods export prices and export volumes. 

Given the current high level of core inflation, members agreed that there was an asymmetry in the distribution of risks to the outlook for monetary policy across the two scenarios. A global slowdown would likely unwind the additional inflationary pressure that has recently been observed, whereas further domestic demand strength would likely necessitate additional monetary tightening. Some members noted that inflation has now been above target for some time, and that there should be a low tolerance for any increase in the time to return inflation to target. 

The Committee noted that the incoming Government’s policy programme will have implications for economic activity and inflation. Members agreed that this would be assessed as policies are formally incorporated into the Treasury’s official forecasts.

The Committee discussed the backdrop of heightened geopolitical tension and risk of spillovers to the global economy. Members noted that whilst they remain attentive to global developments, they will respond to shocks if and when they eventuate. The Committee also discussed the outlook for China and noted that while economic data over recent months have improved, structural challenges facing the Chinese economy remain concerning for long-term growth prospects. Potential growth is slowing, partly due to demographic trends, but also due to substantial declines in productivity growth. High levels of debt, particularly in the property sector, and weak demand remain the most acute downside risks.

Members were cognisant of the likelihood of an El Niño climate pattern in coming months. They noted that the scale of potential impact is highly uncertain and depends on the timing and location of any droughts. There may be differentiated impacts for different agricultural commodities. No specific drought impacts have been incorporated in the economic projection and members agreed they would continue to closely monitor the evolution of El Niño over coming months.

The Committee agreed that in the current circumstances, there is no material trade-off between meeting their inflation and employment objectives and maintaining stability of the financial system. Members noted that slowing economic activity is not being experienced evenly across the economy. The commercial property and agricultural sectors are starting to experience challenges and may be vulnerable. For highly-indebted households, pockets of stress are likely to grow as debt servicing burdens increase.

In discussing their Remit objectives, the Committee noted inflation is still expected to decline to within the target band by the second half of 2024. Pressure in the labour market is easing, although employment remains above its maximum sustainable level. Members agreed that monetary policy was supportive of sustainable house prices.

In discussing the appropriate stance of monetary policy, members agreed they remain confident that monetary policy is restricting demand. Nevertheless, ongoing excess demand and inflationary pressures were of concern, given high core inflation. Members discussed the possibility of the need for increases to the OCR. Members agreed that with interest rates already restrictive, it was appropriate to wait for further data and information to observe the speed and extent of easing in capacity pressures in the economy. 

The Committee agreed that interest rates will need to remain at a restrictive level for longer, to ensure annual consumer price inflation returns to the 1 to 3 percent target range and to support maximum sustainable employment. On Wednesday 29 November, the Committee reached a consensus to maintain the Official Cash Rate at 5.50 percent.

The November Monetary Policy Statement is here.