Opinion: OCR to 6.5% by March 2009

By ASB Chief Economist Nick Tuffley and ASB Economist Jane Turner The RBNZ delivered a surprise 50 basis point cut, bringing the OCR to 7.5% Expectations were centred on a 25 basis point cut. The surprise was deliberate, engineered to bring mortgage rates down. The RBNZ stressed that today's action only brings policy easing forward, and the end point remains the same. We expect the OCR to be cut to 6.5% by March 2009. Focus was on interest rates paid by households and businesses. Elevated funding costs have kept interest rates higher than they otherwise would be. Despite today's cuts the RBNZ still expect the effective mortgage rate to increase. The growth outlook was revised down as expected. The household sector continues to bear the brunt of the economic slowdown. Inflation will remain elevated over 2009, due to the depreciating exchange rate, food price inflation and wage costs. Nonetheless, underlying inflation pressures will ease in line with the weakening economy. Growth lower Compared to June, the RBNZ has revised down its growth outlook "“ as expected. The RBNZ expects GDP to contract in both Q2 and Q3, following on from Q1's decline. Three negative quarters makes for a recession, not just a technicality. The headwinds leading to a prolonged period of sub-trend growth are coming thick and fast at the NZ economy. Slowing trading-partner growth, high import prices, contractionary monetary conditions, further house prices falls, falling employment, higher credit costs and reduced credit availability. Today's cut in the OCR combined with the fall in the TWI over recent months spell relief on monetary conditions at least. Global outlook deteriorates The RBNZ's forecasts for trading partner growth have been pared back substantially since June. In addition, they still see significant downside risks "“ particularly additional concern on Asian and Australian growth slowing by more than previously assumed. Households feel the strain Domestically, the household sector continues to bear the brunt of the slowdown. The RBNZ acknowledged the significant financial strain facing households (for more detail see ASB Economic Note: Strapped for Cash). Effective mortgage rate remains high Given the considerable strain placed on households, the RBNZ's focus today was squarely on the interest rates households are paying. In particular, The RBNZ was likely to have been very mindful of the effective mortgage rate when making today's decision. Even with declines in mortgage rates over recent months, the average mortgage rate households are paying will continue to rise (as a result of fixed mortgage rates being the norm). Making the situation more challenging, the economy has slowed faster, more deeply than expected. The effective mortgage rate is a reminder of the long lags in the system. Risks tipped by weaker growth Stemming from this, the RBNZ demonstrated concern that monetary conditions will remain too tight, for too long and could hinder potential growth. On the other hand, the RBNZ are also still mindful of the risks to inflation. However the downside risks to growth have tipped the scales. Inflation concerns remain On inflation, the RBNZ forecasts inflation to peak at 4.9% in Q3. Inflation is expected to come back to the top half of the target band over the projection period, highlighting the fact there is little room to tolerate upside surprises. However, excluding the impact of the introduction of the Emissions Trading Scheme, inflation comfortably comes to the mid-point. The RBNZ acknowledged the risks to inflation expectations remain. In addition, a sharper than expected exchange rate depreciation also presents another threat to inflation. Should this happen, without an offsetting decline in growth, the RBNZ has warned that interest rates could be held higher than currently projected. Interest rates lower, faster Reflecting the choice to bring policy cuts forward, the 90-day track is projected to fall much more sharply compared to June MPS. By the end of 2008, 90-day bank bill rates are projected to be 70 basis points lower relative to June. However, the 90-day track still bottoms out around 7% - in line with the Banks remarks that the end point in the easing cycle is still expected to be the same. Market Reaction The market had fully priced in a 25 basis point cut, but did not see much chance of a 50 basis point cut "“ so today's OCR came as a large surprise. Interest rate markets have now moved to reflect the lower OCR, with the biggest movements in the short-end and more modest moves further out the curve. 5-year swap has fallen 10 basis points, whereas the fall in 90-day bank bills today capture the full magnitude of the additional easing. The NZD is down against all its crosses, with the TWI dropping 63.90 to 62.80. Implications: RBNZ could cut another 50 in October The RBNZ sees the economy in recession and wants to get the interest rates paid by households and businesses down, and now. To do so it had to surprise the market and the RBNZ delivered. The RBNZ's willingness to deliver a 50 basis point has upped the ante at future OCR reviews. There is now a heightened chance of another 50 basis point cut should the markets start to expect a repeat performance in October. We put a 60% probability of another 50 basis point cut in October as we are putting weight on governor wanting to keep driving effective lending rates down. Absent a nasty turn on the inflation outlook or disorderly exchange rate depreciation, we consider a follow up 50 basis point cut as likely. We expect the OCR to be lowered to 6.50%, but we are now more likely to get there sooner rather than later. * ASB's weekly Economic Notes are available here.