RBNZ holds as expected and indicates will keep OCR low until economy is more robust

By Bernard Hickey

The Reserve Bank of New Zealand has left the Official Cash Rate on hold at 3.0% as expected and said it would keep the OCR low "until the recovery becomes more robust and underlying inflationary pressures show more obvious signs of increasing."

However the Reserve Bank commented that forward economic indicators had firmed somewhat and interest rates were likely to increase modestly over the next two years.

The New Zealand dollar spiked immediately after the 9 am announcement rising in the first few hours of trade to 77.2 USc from 76.5 USc on the slightly more positive tone in the comments. Wholesale interest rates rose a few basis points.

The OCR has been on hold at 3% since July 29 last year. The RBNZ forecast in its December Monetary Policy statement that the 90 day bill rate was likely to rise around 1% over the next two years.

RBNZ Governor Alan Bollard said the outlook for the economy remained consistent with the bank's projections in that December Monetary Policy Statement.

"Domestic economic activity was weaker than forecast through the second half of 2010. September quarter GDP declined unexpectedly, and retail spending appears to have fallen in the December quarter," Bollard said.

“Forward indicators of activity have firmed somewhat. Trading partner activity continues to expand and New Zealand’s export commodity prices have increased further," he noted.

Bollard acknowledged that the GST increase had caused the headline inflation rate to spike higher as expected.  The Reserve Bank Governor is required to keep underlying inflation between 1-3% over the medium term and is allowed under his Policy Targets Agreement to 'look through' one-off price shocks such as rising oil prices or a GST increase.

"But underlying inflation remains comfortably inside the target band," he said.

"As noted previously, while interest rates are likely to increase modestly over the next two years, for now it seems prudent to keep the OCR low until the recovery becomes more robust and underlying inflationary pressures show more obvious signs of increasing."

Here is the RBNZ's full statement below:

The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 3.0 percent.

Reserve Bank Governor Alan Bollard said: “The outlook for the New Zealand economy remains consistent with the projections underlying the December Monetary Policy Statement.

“Domestic economic activity was weaker than forecast through the second half of 2010. September quarter GDP declined unexpectedly, and retail spending appears to have fallen in the December quarter.

“Forward indicators of activity have firmed somewhat. Trading partner activity continues to expand and New Zealand’s export commodity prices have increased further. Within New Zealand, business confidence, across a range of industries, has picked up and imports of capital equipment have grown. Furthermore, there are tentative signs that housing market activity has stabilised, after having trended lower for some months.

“The recent increase in the rate of GST has caused headline CPI inflation to spike higher as expected, but underlying inflation remains comfortably inside the target band.

"As noted previously, while interest rates are likely to increase modestly over the next two years, for now it seems prudent to keep the OCR low until the recovery becomes more robust and underlying inflationary pressures show more obvious signs of increasing.”

ASB Economist Nick Tuffley said the result was as expected and he was sticking to his view that the next OCR hike would be in September.

Here are his comments in full:

The RBNZ continued to signal it wants to be certain the recovery is firmly underway before resuming the tightening cycle. Importantly, it remains comfortable that inflation is contained for now. The RBNZ was a little upbeat on the signs the economy will pick up (from unexpected weakness), with the external environment remaining supportive. We expect the RBNZ will remain on hold until September.

Activity: weak last year, but positive signs noted

The RBNZ noted the outlook for the economy remains consistent with the December Monetary Policy Statement projections.

While noting the unexpected decline in GDP over Q3 and weakness in Q4 retail spending, the RBNZ remains mildly optimistic on the outlook. In particular, the RBNZ’s confidence in the recovery appears to have lifted since December, due to stronger forward indicators.

Along with the continued strength in trading partner growth, the RBNZ noted the pick-up business confidence and the recent surge in imports of capital equipment. This contrasts to a more cautious tone on the investment indicators in December. Nonetheless, the RBNZ will be looking for more firm evidence of sustained recovery before it is willing to unwind monetary stimulus, and we do not think they will receive this confirmation until the middle of the year at the earliest. In addition, while the housing market has ‘stabilised’ it remains very fragile and unlikely able to withstand interest rate increases for some time, particularly as house prices continue to decline.

Inflation: comfortable

The RBNZ remains comfortable with the inflation outlook. This largely reflects the fact Q4 CPI came in line with its December MPS forecast, with the 2.3% increase for the quarter boosted by the GST increase. The RBNZ continues to note that "underlying inflation remains comfortably inside the target band". At the December MPS, the RBNZ had forecast annual headline inflation to head to the middle of the target band by the end of this year on expectations the Q3 and Q4 CPI will be weak. While recent inflation indicators suggest inflation pressures are contained for now, we see upside risk to the RBNZ's medium-term inflation forecast.

Implications: still on hold until September

The key message is the RBNZ will remain on the sidelines until it has sufficient confidence the recovery is entrenched. Our view remains that the evidence for that will be starting to build from mid-year at the earliest. The statement did accentuate the signs that the economy is returning to growth after the unexpected soft patch in the middle parts of last year, and that the external environment remains supportive of recovery (even as household demand remains fragile). Importantly, the RBNZ’s comfort with inflation will reinforce the RBNZ’s decision to stay on hold for a while.

We continue to expect that the RBNZ will wait until September before lifting interest rates, and that the first few increases will be spaced apart. Beyond that, in 2012 we expect the RBNZ’s comfort with inflation to be eroded, and for the pace of tightening to pick up. We expect the RBNZ will lift the OCR in September and December 2011, and in March April, June, July 2012, to a peak of 4.5%.

Market reaction:

Interest rates were steady on the run in the RBNZ meeting, and the NZD was likewise little changed. The FOMC announcement at 8.15am NZT passed without much of a stir in the market, as it contained no surprises. Likewise, a short statement from the RBNZ at 9am gave no real reason for a change in market sentiment, and interest rates were little changed, lifting 1-4 basis points, but still well within the weekly range. Swap rates have rallied slightly lower over the week, and market pricing is broadly in line with our expectations of two rate hikes by the end of 2011. The NZD has now squeezed higher, having been slightly directionless in the minutes following the meeting. The NZD has lifted around 0.5 cent against the USD and the AUD.  

JP Morgan economist Helen Kevans noted the more positive tone in the comments about the outlook and stuck to her forecast for the next OCR hike being in June.

The short commentary accompanying the RBNZ’s expected ‘no change’ decision this morning was not as downbeat as we had expected. Governor Bollard noted the recent weakness in domestic activity, but focused most of his attention on the economic outlook.

Owing to the more promising outlook, Dr. Bollard maintained that the OCR likely would “increase modestly over the next two years”. For now, though, “it seems prudent to keep the OCR low until the recovery becomes more robust and underlying inflationary pressures show more obvious signs of increasing”. Indeed, accommodative policy settings should be left in place to help encourage the resumption of the recovery that was, until recently, underway.

Our forecast remains that the OCR will remain at 3% until at least June, with the risks skewed toward a later move should the economic data continue to disappoint.

The Governor acknowledged today the recent weakness in activity, including the unexpected contraction in the economy in 3Q and the drop-off in retail sales in 4Q. Much more emphasis was placed, though, on the outlook, with the statement acknowledging the recent improvement in the forward looking indicators.

The most recent NZIER Quarterly Survey of Business Opinion, for example, showed a bounce in the own-activity measure in 4Q (from a net -15% in 3Q to a net -1%), increasing our conviction in our forecast for modest, positive growth in the final three months of 2010; thus, the evasion of a technical recession. Other positives noted included continued strong trading partner growth, elevated export commodity prices, firmer business confidence, early signs of stabilization in the housing market, and an increase in imports of capital equipment.

The latter reaffirms our view for stronger business investment in coming quarters, which should help the recovery in the labour market gain traction, and the deleveraging headwind facing the to fade. Indeed, household balance sheet repair is the main reason why underlying inflation remains benign, and within the Bank’s target range as acknowledged in the statement today. In the absence of a rise in the goods and services tax (GST) on October 1, quarterly CPI would have printed at a mere 0.3%q/q.

Indeed, the current price environment provides little imperative to lift the OCR back toward neutral. Underlying inflation is weak, price expectations low, and firms lack pricing power given the persistent weakness in domestic demand; thus, low interest rates should be maintained for some time.  

(Updated with currency reaction, wholesale int Bollard comments, ASB economist reaction, JP Morgan economist reaction)