Reserve Bank holds OCR at 2.5%; expects to hike 'over coming months' (Update 5)

The Reserve Bank of New Zealand has held the Official Cash Rate at 2.5% and signalled it will hike it 'over the coming months'. This compares with the previous 3 statements that signaled it would raise rates in the 'middle of this year'. (Updates with: Details on Bollard's reasons why the RBNZ's monetary policy will be more potent and rates may not need to be hiked as much in future; My View that rates needed to rise earlier; Charts showing rising use of floating mortgages; ASB Economist Nick Tuffley's view that a July rate hike is most likely; ANZ economist Khoon Goh's changed view of the first hike being in June rather than September; BNZ's Stephen Toplis saying the first hike will be in either June or July and the OCR could be 3.75% by the end of the year) Governor Alan Bollard said the economy was recovering in line or slightly faster than the bank's forecasts in March, partly because of a stronger rebound in Asian economies. However, consumer spending and business investment remained weak and credit growth was restrained, he said. He added that bigger margins between lending rates and the Official Cash Rate (OCR) meant future rate rises may not need to be as big as in past because future OCR rises would be more effective. My view The Reserve Bank has slightly opened its forecast window for the first rate hike by a month or two in this statement. It now has the flexibility to delay the first hike to September 16 from the previous window of June 10 and July 29. Governor Bollard has the leg room to stretch out a bit because inflation remains contained and the squeeze currently on bank lending, along with a rightly cautious bunch of consumers, is keeping the pressure off prices in the local economy. He also has two new 'tools' which are allowing him to hold the OCR and still effectively tighten retail interest rates. Firstly, the Core Funding Ratio introduced from April 1 and a push by the banks themselves to wean themselves off the 'hot wholesale money markets' has effectively engineered a slight tightening in actual retail interest rates, despite the flat OCR. This will continue as the funding ratio tightens further over the next two years to 75% from 65%. KPMG estimates this could increase lending rates by a further 50 basis points, although the Reserve Bank thinks it will be less. The Core Funding Ratio forces the banks to fund their lending from more stable and longer term sources such as long term bonds or local term deposits. These more stable funding methods are more expensive for the banks and they have passed on the costs in the form of higher lending rates. Since April 30 last year, when the Reserve Bank cut the OCR to 2.5%, the average 2 year fixed mortgage rate has actually risen from 6.24% to 7.13%, Interest.co.nz data shows. This is partly to account for the average 1 year term deposit rate having risen from 4.39% to 5.05% over the same period. Secondly, borrowers are increasingly opting for floating mortgage rates, which are lower than fixed rates for the first time in a generation. Since April 30 last year the average floating mortgage rate has fallen from 6.34% to 5.86%. This is known in the business (and referred to in the Governor's statement, as curve steepening. Longer term rates have risen, but shorter term rates have fallen. This means that around 30% of mortgages in New Zealand are now floating, almost double what it was at the peak of the housing boom when banks were able to keep fixed rates lower than variable rates because they could suck in cheap foreign money from the 'hot' wholesale money markets. Strangely enough, borrowers are going for the cheaper option. KPMG estimates that around 70% of new mortgages being written are now floating. This is why the Reserve Bank now feels confident that it can wait a teeny bit longer. It believes that when it does hike the effect on the economy will be more immediate and it won't have to raise the rate as high as in the future. Fair enough. It is good that the Reserve Bank has these extra powers, both directly through the Core Funding Ratio and indirectly through the curve steepening. But I still think the Reserve Bank should have hiked today or should at least have stuck to its previous time-table of a 'middle of 2010' hike. The Reserve Bank of Australia has already hiked 5 times since October last year and is widely expected to hike for a sixth time to 4.5% next week. It is experiencing the biggest mining boom in over a century and it is our biggest trading partner. The New Zealand dollar has fallen sharply against the Australian dollar, boosting returns for exporters to Australia and encouraging droves of tourists to come here. Commodity prices are at record highs. China is also tightening to slow its economy from a break-neck pace of 11.9% growth in the first quarter. It is also cracking down on a credit-fueled real estate bubble that is spilling over the sides into the Canadian, the Australian and Auckland markets. China is now our second biggest buyer of exports after Australia. Consumer spending in New Zealand, particularly with credit cards, is picking up again and business confidence surveys are signalling GDP growth of 4-5% in the year ahead. Leaving interest rates at 2.5% seems a tad risky with that sort of growth outlook. Your view? We welcome your thoughts and insights below. The full Reserve Bank statement is below:

The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 2.5 percent. Reserve Bank Governor Alan Bollard said: "The New Zealand economy is recovering broadly as expected and growth is predicted to pick up further through 2010. "Trading partner activity has recovered more quickly than we expected. Growth in Asia has been particularly strong. Consistent with this, export commodity prices have increased close to their 2008 peak. At the same time, risks to the global outlook remain elevated. "Notwithstanding the impact of stronger than expected export earnings, New Zealand households remain cautious, with the housing market and household credit growth subdued. Similarly, business spending is weak and firms continue to reduce debt. "On balance, we continue to expect the New Zealand economy to recover in line with or slightly faster than our March Statement projection. Annual CPI inflation, which has been close to 2 percent for the past year, is expected to track within the target range over the medium term. "As previously indicated, we expect to begin removing policy stimulus over the coming months, provided the economy continues to evolve as projected. "The increased wedge between the OCR and lending rates, as well as a steeply positive-sloped interest rate curve, is expected to make OCR increases more effective than in the past. Accordingly, these factors should reduce the extent to which the OCR will need to be increased relative to previous cycles."

ASB Economist Nick Tuffley said the 'coming months' phrase appeared similar to the 'middle of 2010' phrase used earlier, but the Reserve Bank had given itself more 'wriggle room'. Tuffley said he still favoured a July hike, but a June hike was still possible.

The RBNZ remains wary of the current dichotomy between the stronger export outlook and sluggish domestic demand. In particular, the Bank remains concerned by the weakness in business spending and reduction of debt in this area. The Bank is possibly looking for more concrete evidence that businesses are willing to translate upbeat confidence into action, such as increased investment and employment. The RBNZ reiterated its expectations that it expected annual CPI “to track within the target range over the medium term”. We continue to see upside risks to that inflation outlook. While the Q1 CPI was broadly in line with the March Monetary Policy Statement forecast, recent business surveys are showing a continued increase in pricing intentions, and capacity utilisation is trending upwards. It appears the excess capacity that had developed over the recession is rapidly diminishing, and we expect this to be reflected in a rebound in non-tradable inflation over the coming year. Added to that, there are a host of administrative inflation that will occur through to 2012. This includes the 10% increase overnight in tobacco excise tax (and further 10% increases in 2011 and 2012), higher petrol and electricity prices from the implementation of the Emissions Trading Scheme, and higher vehicle licensing fees from the ACC levy increase. Furthermore, it is likely the Budget will announce an increase in GST from 12.5% to 15%. Including all these factors, we expect annual CPI inflation to rise above 5.5% by mid-2011. While the RBNZ is expected to look through first-round effects of any “significant government policy changes that directly affect prices”, there is a very real risk that the higher headline CPI will spill over to wider inflation via changes in price and wage setting behaviour. The fact that medium-term inflation expectations are already elevated at 2.7% is concerning. Even if we exclude ETS and the GST increase– as the RBNZ has done for its central inflation projection – annual inflation is likely to rise to 3.3% by mid-2011. The RBNZ has given itself room to manoeuvre, still leaving a lot of wriggle room with its signal it expects to begin removing stimulus over “coming months”. Effectively that signal is still “around the middle of 2010”. The RBNZ is more optimistic on the strength of the near-term recovery than we are. However, from an inflation point of view the RBNZ still appears to us to be undercooking the extent of future pressures. There are a number of wild card factors over the next few months, including employment, the Budget (for which the RBNZ has been very direct in saying it is looking for more fiscal consolidation), the housing market and consumer spending, and also the recent developments in Europe. We favour a July increase, given the number of uncertainties arising, and a series of 25bp moves to 5%. However, with inflation quickly becoming a very uncomfortable picture, the RBNZ can’t rule out the need to go as early as June. Markets will be left guessing for now, with OCR expectations swinging on every key release over the next 6 weeks.

ANZ economist Khoon Goh said ANZ had changed its view of the first hike being in June rather than its previous view of September because of signs of a strengthening recovery.

As we had expected, the RBNZ replaced the mid-year phrase with “over the coming months”, which effectively gives them wiggle room in terms of when to begin the tightening cycle. We take “the coming months” as a toss up between June and July. September simply feels too late despite the attachment of some conditionality ("provided the economy continues to evolve as projected") and the fact that the near-term data outturns suggest that growth over the first half of this year is unlikely to match the RBNZ’s 1 percent per quarter expectations. However, this must now be balanced against some positive H2 2010 and 2011 growth dynamics such as strong global dairy prices that, if maintained around US$4,000/tonne (and if sovereign tensions in Europe stop the NZD/USD moving up too far) imply the dairy payout may have a 7 in front of it for next season. This, alongside strengthening business confidence, suggests that the RBNZ has downplayed somewhat the recent softness in the domestic data. We concur with this, and believe prospects for 2011 are starting to look very robust. In terms of June versus July, we are now more inclined towards the former, and are formally changing our call from September to June. There is nothing magical about this apart from the fact that we believe turning points in the monetary policy cycle should have the benefit of a full Monetary Policy Statement, which allow the "plan" to be better conveyed. Of course this could be done in July as well so we are really talking semantics here. After all, the easing cycle in 2008 did start on a Review date. NZ data is notoriously volatile and prone to "switching" on and off. We are detecting that the switch is about to be flicked on. This is based on recent anecdotes we have been picking up in our travels around the country, and the strength in recent business confidence data. If we are correct, we believe there will be enough evidence by the June Statement for the RBNZ to begin removing policy stimulus. Of course, this will not all be one-way traffic. We fully expect some dynamics such as business investment to remain subdued for a while yet, and for deleveraging to still be a key feature across the economy. We find the former somewhat problematic in terms of what it implies for the supply-side capacity of the economy – and the impact on inflation. Beyond June we are inclined to pencil in 3 more hikes which takes the OCR to 3.5 percent by October, and then a pause to assess the water, before heading towards the endgame at around 5.5 percent. As the RBNZ notes, “The increased wedge between the OCR and lending rates, as well as a steeply positive-sloped interest rate curve, is expected to make OCR increases more effective than in the past. Accordingly, these factors should reduce the extent to which the OCR will need to be increased relative to previous cycles.” We are also mindful of the potential for the odd global setback, and also the considerable structural changes that will impact the economy over the coming year (i.e. the tax system which is likely from October 1). In addition, the data is likely to be very noisy. In that set of circumstances, and given the slope of the yield curve, going early (June) would appear to give the RBNZ more flexibility to be gradual over the pace of tightening. Or put it another way, it is difficult to see 8 or more successive 25bps hikes in the OCR immediately given the current state of the housing market. If there is an upside risk to this view at present (and where we would see the neutral interest rate), it stems from pending terms of trade gains. However, further extensions in NZ’s commodity prices from this point require the China growth story to kick-on further. Given inflationary pressures there and steps by Chinese policymakers to cool their economy, this will be a challenge. In terms of the overall policy assessment, it was short and balanced. Upside surprises were noted, particularly the recovery in NZ’s trading partner growth and high export commodity prices. Specifically, the RBNZ sees some upside risk to NZ economic growth compared to their March projections. But the RBNZ still noted risks to the global outlook, which they describe as “elevated”. The Bank’s view on the domestic economy was more guarded, noting cautiousness amongst households, subdued housing market and credit growth, and weak business spending. Despite some obvious one-offs that is set to send headline inflation past 5 percent this year (tobacco tax increases, emissions trading scheme charges, possible GST increase), the RBNZ has not expressed any concern over inflation, expecting it to track within the target range over the medium term. This suggests the RBNZ is focused on underlying inflation and will only focus on potential second round impacts, as they should. Interestingly, no mention was made of fiscal policy this time. While government policy, such as the surprise decision to raise tobacco taxes overnight, is set to push headline inflation higher, there is no doubting that fiscal consolidation is underway and that the fiscal stance is moving into contractionary mode. This should assist monetary policy rather than work against it.

Westpac economist Brendan O'Donovan said he still thought the Reserve Bank would hike in June.

This morning the RBNZ left the OCR unchanged at 2.50%. With the next review falling on 10 June, this means the RBNZ has now fulfilled its commitment to keep rates at current levels until around the middle of the year. The flipside is that the RBNZ is now free to begin normalising policy settings at any time; and without spelling it out too finely, today's statement has confirmed that every OCR review from here on is 'live'. We said that the wording of the statement would be tweaked to reflect the fact that the start date for hikes is drawing closer, and what the RBNZ delivered was remarkably similar to what we had in mind. The key sentence of the statement was: "As previously indicated, we expect to begin removing policy stimulus over the coming months, provided the economy continues to evolve as projected." The previous indication was actually for hikes to begin "around the middle of 2010" rather than "over the coming months". That change in wording might seem like a step sideways, since it's just as opaque about the timing. But the RBNZ was never going to lock itself in to a specific date anyway, and the new wording makes it clear that hikes could come at any review from here on. Indeed, a rate hike at every review over coming months could still qualify as "beginning" the tightening cycle, in light of how much work lies ahead of the RBNZ in the next couple of years. The RBNZ noted that the New Zealand economy is tracking in line with, or slightly stronger than, the forecasts in the March Monetary Policy Statement. The domestic drivers of growth still look relatively subdued, with retail spending and housing turnover slowing in the early part of this year. Business spending has been weak to date, and firms continue to reduce debt (which implies the RBNZ views falling business lending as a product of low demand rather than constrained credit). On the plus side, the global economy has continued to recover faster than expected, with a particularly impressive rebound in our major trading partners in Asia and Australia. Strong demand has boosted prices across a range of our commodity exports, while the relatively low exchange rate against the Australian dollar has been a boon to other export-heavy sectors such as manufacturing. Global growth is still very lopsided, with Asia ex-Japan and increasingly the US racing ahead, while Europe and Japan remain in the mire - but that's not all that different from the last boom. The RBNZ's comments on inflation were unchanged, with no mention of the March quarter outturn of 0.4% (which is appropriate, since it wasn't a surprise to the RBNZ). Annual inflation is expected to track within the 1-3% target range over the medium term - but remember that the RBNZ always forecasts itself to achieve its inflation target, with the right policy settings. The March MPS forecasts were based on a steady but substantial tightening over the next few years. The statement ended with a suggestion that OCR hikes may be more effective this time than in previous cycles. First, the higher cost of bank funding as a result of the global financial crisis means that the OCR won't need to go as high as it would otherwise. Second, the upward-sloping yield curve means that more borrowers have migrated to short-term rates, leaving them more exposed to OCR changes. We don't agree with this assessment. As we discussed in our latest quarterly Economic Overview, the idea that higher funding costs mean a lower average OCR runs up against the question: "lower than what?" Pre-crisis financial conditions were hardly normal either. And although the shape of the yield curve is certainly more helpful than it was in 2007 when the RBNZ last hiked rates, that's the wrong point of reference - we're at the start of a tightening cycle, not the tail end of one. The share of mortgages on floating rates is no greater today than it was at the start of previous tightening cycles. But setting aside our objections, these are really issues for monetary policy over the next few years, not the next few months. Market implications Given that the statement firmed up the message that rate hikes are on the way, the initial market reaction was curious: swap rates and the NZ dollar fell on the announcement, and while interest rates have reversed course and ended a few points higher, the NZD remains about 50pts lower at 0.7160. It may be that traders were caught out by a reordering of the statement - skipping to the last paragraph to get the 'bias' on the next policy move, they were instead confronted with a discussion of why the OCR may not need to rise as far as in past cycles. We should point out that these comments were no different from what was said in March, just given slightly more prominence (and we didn't agree with them then either). We also note that it's common for the RBNZ to temper a 'hawkish' message with some softly-softly statements, if only to stop market pricing from running too far ahead. As we said in our preview, divining the RBNZ's thinking on the timing of the first OCR hike is more a matter of bragging rights for economists. So on today's statement we're going to allow ourselves a quiet "told you so". In contrast to the second-guessing going on in financial markets in recent weeks, the RBNZ is clearly comfortable that the recovery is tracking as expected, which means there's no need to delay the normalisation of policy settings any longer. We continue to expect a 25bp hike in the June MPS. No doubt, some will argue that the phrase "over coming months" was intended to give the RBNZ room to delay hikes until July or even September. Interest rate markets are still in two minds, giving a two-thirds chance of a June hike. We can't rule out a later tightening, but it's really a matter of knowns versus unknowns. Sure, European debt markets might implode in the next six weeks, which would see rate hikes deferred at the very least. But based on what we know as of today, we see no reason to expect a delay beyond June.

BNZ economist Stephen Toplis said a June or July hike was still on the cards.

We still can’t be sure whether the RBNZ will pull the trigger in June or July. That shouldn’t be a surprise as it’s abundantly clear the Reserve Bank is not so sure yet either. Today’s OCR review was about as ambivalent as possible about the specifics while being absolutely consistent with past commentary that the tightening cycle will start at the middle of this year. On balance, it looks as if the RBNZ has become a tad more optimistic about the outlook but mindful that such optimism is tainted by a higher risk profile, especially surrounding recent developments in European financial markets. But while the growth optimism is slightly heightened, CPI concerns are not. And it’s the CPI projection that drives policy. Hence, nothing changes. For the record, our published view is that the Bank will push the cash rate to 3.75% by year’s end in 25 point steps, but this is a purely indicative track with the risk being that rates are actually raised more aggressively than suggested. The most important thing to be right now, however, is flexible with one’s view. Unless you can be entirely confident of your macro and financial forecasts, you can’t be entirely confident of the accompanying interest rate track. Giving oneself room to manoeuvre is thus imperative – and that’s exactly what the RBNZ has done for itself in today’s statement. We commend it for doing so. Nonetheless, while the detail of the interest rate trajectory ahead is still very open to conjecture, two key messages remain: the cash rate will very soon begin to climb; and it will continue to climb to a cyclical peak that will invariably end above neutral. For trading folk the detail matters, but for most others the important news is get used to rising interest rates and prepare yourselves accordingly.