RBNZ to cut OCR 25 bps as exports see tough times and rates rise, ASB says

The Reserve Bank of New Zealand will cut the Official Cash Rate by 25 basis points to 2.25% on September 10, ASB economists expect. Recent tightening of monetary conditions, with both long term interest rates and the New Zealand dollar heading higher, would put pressure on the RBNZ to cut, despite reasons for the central bank to hold the OCR at its record low of 2.5%, they said. As well as tighter monetary conditions and a high NZ dollar, ASB Chief Economist Nick Tuffley and Economist Jane Turner said the impact on exports had yet to be fully felt, with a lot of belt-tightening to come in dairying regions despite the recent news on the rise in milk powder prices. Tourism would also come under pressure with the end of the ski season, they said. Weak credit growth and a loss of momentum in the housing upturn could also help lead to a cut in the OCR, they said, with credit to be further constrained by the phasing out of the retail deposit guarantee. "We are tipping our hat to a 25bp cut on September 10, but we freely acknowledge that we are in a distinct minority in suggesting the RBNZ will cut," they said. "Market pricing implies only a 10% chance of a cut. At the very least, the RBNZ is likely to try and reinforce that OCR increases are a lot further off than the market is pricing in. However, without action to accompany this stance, continued jawboning will fall on deaf ears." Tuffley and Turner said the RBNZ may wish to hold the OCR at 2.5% following signs that the economic outlook is stabilising:

The global economy is stabilising. Over recent months, forecasts for global growth have been revised up, led by Australia averting recession and a strong bounce back in Chinese economic activity. Consensus forecasts now imply a slightly better global outlook than the forecasts incorporated in the June MPS. Fonterra's on line dairy auction has shown encouraging signs that prices are recovering. Business confidence has recovered substantially. The housing market has lifted markedly off its lows and the increased level of demand is likely to remain underpinned by the pick up in net migration. Retail spending data suggest consumer spending growth is already recovering and in our view won't be as weak over the next few years as the RBNZ has assumed. The RBNZ may be reluctant to cut the OCR further, if only to reduce the risk of fuelling the household-led recovery which could slow the correction in NZ's external indebtedness.

However, there were reasons to cut, with risks to the inflation outlook remaining on the downside, Tuffley and Turner said, adding that the RBNZ needed to be wary that doing nothing would risk killing off the recovery when it remained fragile:

NZ monetary conditions are being dragged higher as global prospects improve, particularly as expectations for higher Australian interest rates get brought forward. New Zealand is experiencing a defacto tightening because of Australia's better economic outlook. An OCR cut would be a very clear-cut way of differentiating NZ's more precarious economic recovery from Australia's relatively robust performance. Long-term mortgage rates are back to, or above, long-term averages. It is really only rates out to 2 years that are outstandingly cheap and can be thought of as stimulatory. Even then, these shorter rates have started to lift more recently as markets bet on the RBNZ tightening much sooner than the RBNZ implies it will. The higher NZD is also contributing to tighter monetary conditions. The RBNZ has assumed for the past 6 months that the NZD will fall to a very low level and remain weak for several years. However, it has become increasingly clear that this may not be the case. The primary reason the RBNZ expected the fall was based on NZ's huge external financial liabilities. However, if those liabilities didn't cause the NZD to fall when the crisis was still fresh, why would they when the crisis is steadily on the mend? The impact on exports has yet to be fully felt, in particular the strength in the NZ dollar will make any export-led recovery very difficult. The positive news from the dairy auction is primarily that there is less risk of Fonterra cutting the 2009/10 payout from $4.55. Even then, there is going to be a lot of belt-tightening in dairying regions. Tourism is under pressure outside ski tourism, and will remain under the gun. Yes, the housing market is recovering. But the recovery to date is still weak. Sales turnover has lifted sharply, but the increase has lost some momentum since April and mortgage rates have now started to rise. Mortgagee sales numbers continue to rise. There is low risk that another OCR cut will trigger a huge mortgage lending boom. Credit growth remains weak and symptomatic of a struggling economy. Mortgage lending data published by the RBNZ is running below an annual pace of 3%, by far the weakest pace on record. Consumer lending also shows little sign of recovering, having shrunk nearly 4% over the past year. Business credit demand is weak. Inflation is likely to bounce around the bottom of the target band over the next two years, meaning the risks are skewed to uncomfortably low inflation. Wage growth has weakened earlier than the RBNZ has assumed. The RBNZ's new liquidity policy will encourage banks to concentrate on funding via the more expensive but more stable sources: retail deposits and long-term funding. All else equal, this will put further upward pressure on lending rates. Phasing out of the retail deposit guarantee scheme will further constrain credit provided by the non-bank sector, particularly consumer credit.

Tuffley and Turner said it is possible the RBNZ concludes the economy is on the mend and believes the tightening underway is warranted. "However, such an outcome seems unlikely given Dr Bollard's still-cautious comments over the past week." "We expect the RBNZ still views the tightening in monetary conditions as undesirable. In July's OCR review the RBNZ said its forecast recovery was "based on a further easing in financial conditions" and could be at risk without that easing. Developments since then have been positive, but not enough to make up for the huge gulf between current monetary conditions and the RBNZ's outlook for them. At some stage the RBNZ is going to have to build in a substantially higher NZ dollar into its economic outlook than it has to date." "The risk with cutting is that it may not have any lasting effect. But if the RBNZ is genuinely worried about overly tight monetary conditions it should act rather than hold back for any fears of being perceived as ineffective."