RBNZ leaves OCR at 2.5%; says this level likely “for some time,” but takes out mention of tightening when Chch rebuild begins

By Alex Tarrant

The Reserve Bank has left the Official Cash Rate (OCR) unchanged at 2.5%, in line with economist and market expectations, but its comments about inflation and future interest rate moves were softer than the market expected.

The New Zealand dollar and wholesale interest rates fell as markets pushed back their expectations for a hike in the OCR into 2012. Economists had previously expected the OCR could be increased as early as December with most seeing a hike in the first quarter. See our article previewing the decision here.

The RBNZ said the current OCR level was “likely to remain appropriate for some time,” but it removed its comment made in March that “current monetary policy accommodation will need to be removed once the rebuilding phase materialises” in Christchurch.

The Reserve Bank appeared comfortable with the medium-term inflation outlook, saying annual inflation was likely to settle comfortably within its 1-3% target band once indirect tax increases, such as the GST hike on October 1, dropped out of the annual inflation rate.

The central bank also fired shots across the bows of the high New Zealand dollar, which touched 81 US cents yesterday, and high oil prices, saying these could dampen economic activity. The New Zealand dollar fell to 80.3 USc in initial trade after the 9am statement from 80.8 USc before. The NZ dollar also slumped vs the Australian dollar to below 74 Australian cents.

Economists have been picking the RBNZ would hold the OCR at its current ‘insurance level’ until at least December as the economy recovers from the impact of the February 22 earthquake that hit Christchurch.

Outlook still very uncertain

The Reserve Bank said the outlook for New Zealand’s economy remained “very uncertain” following the February earthquake. Firms and households in Christchurch were still under pressure, although the rest of the country appeared relatively unscathed.

“As was expected, business confidence, consumer spending and tourism activity all declined sharply following the earthquake,” the RBNZ said in a statement.

“The OCR was cut as insurance to help limit these adverse effects. Confidence and consumer spending have since shown signs of recovery, but many firms and households remain adversely affected in Christchurch,” the RBNZ said.

“To date, activity in the rest of the country appears relatively unaffected, with housing market turnover and business investment beginning to increase.”

The latest National Bank Business Outlook Survey released yesterday showed general business confidence rebounded somewhat in April after a heavy slump in March due to the February quake.

Exporters doing well, but high oil prices, dollar hurting

New Zealand’s trading partner growth remained robust, helping push New Zealand’s export commodity prices higher, the RBNZ said.

“Along with relatively favourable climatic conditions, the improved price outlook is supporting a pickup in on-farm investment,” it said.

“Higher oil prices and the elevated level of the New Zealand dollar are both unwelcome. They will have some dampening effect on economic activity,” the RBNZ said.

These comments come after markets interpreted remarks from Reserve Bank Governor Alan Bollard earlier this month as green-lighting the rise in the New Zealand dollar.

 In a speech to a farming group in Ashburton on April 11, Bollard said an improved terms of trade for New Zealand was likely to continue to be reflected in the exchange rate. The Reserve Bank would focus on medium-term inflation rather than the terms of trade, Bollard said in the speech. See his comments in Bernard Hickey's article here.

Meanwhile, the New Zealand dollar fell against the Australian dollar after the Reserve Bank's statement this morning. The Australian dollar jumped yesterday after a surprise jump in inflation, meaning prospects for an interest rate hike in Australia increased. See more in 90 seconds at 9am here.

The New Zealand government has been keen to note the effects of such a low New Zealand dollar against the Aussie as Australia is New Zealand's biggest single export market.

Inflation to settle

Headline inflation was currently being boosted by recent increases in indirect taxes, the RBNZ said.

The Reserve Bank is currently tasked with keeping medium term inflation in a band of 1-3%.

The latest CPI inflation figures from Statistics New Zealand showed annual inflation in the March quarter was 4.5% - about half of which was put down to the GST increase on October 1. The Reserve Bank said at the time of the increase it would look through the short term inflation effect of the GST hike.

“Annual inflation is expected to settle comfortably within the target band once these tax increases drop out of the annual rate,” the Reserve Bank said.

“Given the outlook for core inflation and continued economic disruption stemming from the earthquakes, the current level of the OCR is likely to remain appropriate for some time,” the RBNZ said.

BNZ economists were thrown by the Reserve Bank's currency comments:

Although the RBNZ was all predictability and consistency in respect to its economic and OCR view it wasn’t at all in respect to the currency.

Having spoken a couple of weeks ago about New Zealand’s very high terms of trade partly justifying the strength of the NZ dollar, Bollard today seemed to back right off that with the sentence “Higher oil prices and the elevated level of the New Zealand dollar are both unwelcome”.

Would the Bank’s true attitude toward the exchange rate please stand up? Maybe all it was really trying to say was that it didn’t want the currency to keep ramping up? Who knows? The NZD itself was hit about half a U.S. cent at the bell, but has since stabilised.

While the Bank’s OCR statement today gives the impression of a super-cautious central bank, uncertain of the way ahead, it doesn’t really change our macro expectations, including on the OCR. We still believe that over the second half of this year there will not only be increasing evidence the economy is powering up, in spite of material disruptions from the February earthquake, but also that inflation won’t be fading nicely to the mid-point of the target band the way the RBNZ presumes.

So we’ll stick to our December rate hike call, of 25bps, as the start of a cycle that will have the OCR back up to 5.00% in about two years’ time. We know this is more aggressive the current market pricing (and a little more so after today’s 2-4bps softening in wholesale interest rates). However, we are sticking to our guns.

ASB economist Nick Tuffley comments:

The RBNZ kept the OCR on hold.  Although it seems more comfortable the economy will hold up in the wake of the earthquake, the high NZD and oil prices were seen as “unwelcome”.

Growth: a little more confident

The RBNZ noted the drop in confidence following the earthquake, and the subsequent recovery in part buoyed by the cut in the OCR.  While firms and households in Christchurch remain adversely affected, the RBNZ noted that the rest of the country seems relatively unaffected.  This is an encouraging sign the remainder of the economy is holding up well despite the earthquake.  Indeed, housing market activity (particularly in Auckland) and business investment has started to increase outside of Christchurch. 

The RBNZ is also more upbeat on the rural sector, noting the increase in NZ export commodity prices, which along with favourable weather conditions has helped supported a pick-up in on-farm investment. This is a slight change from the March statement, in which the RBNZ noted that farmers had been focusing on repaying debt rather than spending.  This is an area the RBNZ is likely to watch closely over the next year.  A recent speech by the RBNZ warned higher export incomes may stimulate increased investment and borrowing activity, which may contribute to higher inflation pressures, which in turn the RBNZ would react to.  Nonetheless, the NZ dollar is playing an important role in buffering the higher returns, although the RBNZ noted that the higher dollar was currently ‘unwelcome’ to the extent it is dampening economic activity.  This suggests the RBNZ may also see US dollar weakness as a factor behind the high level of the NZ dollar, along with high commodity prices.  High oil prices also remain a key risk to the growth outlook.  Overall, the statement suggests the RBNZ may be slightly more confident in the economic recovery outside of Christchurch, although a large number of uncertainties remain.

Inflation: still very comfortable

The RBNZ remains comfortable with the inflation outlook, noting its expectations for annual inflation to fall back below the top of the target band of 3% once the tax increases drop out of the annual rate later this year. We continue to think the RBNZ is being too optimistic in its medium-term inflation forecast, given it relies on some weak CPI outcomes over the coming years in order for annual inflation to move back within the target band. While inflation indicators point to inflation pressures in the NZ economy being contained for now, we expect inflation pressures to re-emerge next year as post-earthquake reconstruction gets underway. Rebuilding activity over 2012 is likely to soak up excess capacity in the building sector and see a lift in underlying inflation. 

Market reaction: overdone?

The NZD dropped 0.7c against the USD immediately after the statement. We see this as a bit of an over-reaction, given the decision to hold was unanimously expected, and the RBNZ language surrounding the level of the NZD does not suggest to us that intervention is on the cards. The RBNZ commented “higher oil prices and the elevated level of the New Zealand dollar are both unwelcome” as they “will have some dampening effect on economic activity.” If they had chosen to describe the NZD as unjustifiably high, or listed some of the criteria for intervention, the currency drop would be more understandable.  The interest rate reaction was a 5 basis point dip in yields, as the market focussed on the RBNZ’s comfortable outlook on inflation, and statement that “the current level of the OCR is likely to remain appropriate for some time.”

Implications

The statement doesn’t give any further clues as to when the RBNZ will begin to lift interest rates.  The comments were mixed.  The RBNZ does see little chance of the wider economy getting pulled down by the earthquake, with some tentative signs of pick-up since the March OCR cut and commodity prices till favourable.  However, oil prices and the high NZD have potential to dampen the economy to a greater extent than the RBNZ would have factored in back in March.

The weakness in the NZD after the statement appears an over-reaction to the “unwelcome” level of the NZD.  Despite that reference, it is unlikely the RBNZ will intervene to try and blunt the NZD.  With commodity prices firm and the USD on the back foot, intervention is unlikely to be effective and current circumstances don’t meet the RBNZ’s criteria for acting.

We continue to expect that the RBNZ will refrain from lifting the OCR until March 2012.  Timing will be heavily influenced by when earthquake reconstruction picks up steam, but the most likely window is December – March.  Market pricing is erring on the early end of that window.

Westpac chief economist Dominick Stephens

The RBNZ's press release gave little guidance on the timing of future OCR changes, noting only that "the current level of the OCR is likely to remain appropriate for some time." This amounts to a fairly "straight bat" approach, maintaining the status quo. We continue to expect the RBNZ will move to hike the OCR only once reconstruction work in Christchurch is firmly under way - most likely next year. 

The assessment of recent economic developments was upbeat. The RBNZ mentioned that nationwide economic activity had held up despite the Christchurch earthquake, trading partner growth has remained robust, and export commodity prices had pushed higher. 

But despite the improved economic picture, the Reserve Bank is very comfortable with the inflation outlook. Headline inflation is expected to settle comfortably within the target band once tax increases drop out of the annual rate. The Bank also noted that the high level of the New Zealand dollar was "unwelcome", and would have some dampening effect on economic activity. 

Assessment

We continue to expect the RBNZ will leave the OCR unchanged this year, before hiking in January 2012. Yes, the economy is holding up surprisingly well. But the economy is currently operating well below its productive capacity. There is ample room to grow before encountering inflationary speed limits. And the strong exchange rate will continue to dampen inflation for some time. The main threat to inflation - bottle-necks associated with Christchurch reconstruction - is unlikely to arise before 2012. 

Once the hiking cycle is underway, however, we expect it could be steeper and more prolonged that markets are currently anticipating. 

Market reaction

Before today markets were becoming increasingly interested in the idea of OCR hikes this year. Today's OCR review failed to vindicate that view. Consequently, markets interpreted the statement as relatively dovish. The NZD fell half a cent and 2-year swap rate fell 6 basis points. However, markets are still pricing a 60% chance of an OCR hike by December this year. We think that is too high.

JP Morgan economist Helen Kevans:

RBNZ Governor, Alan Bollard, left the official cash rate (OCR) steady this morning, as was unanimously expected by all economists surveyed by Bloomberg. Having only just cut the key rate 50bp to a record low 2.5% in March as an insurance measure to mitigate against the adverse impacts of the recent earthquakes, there was no immediate pressure on Dr. Bollard today to reverse the move; there will not be any such pressure in the near term. Indeed, the Governor made clear today that given the “outlook for core inflation and continued economic disruption stemming from the earthquakes, the current level of the OCR is likely to remain appropriate for some time”.

The neutral statement implied the RBNZ has adopted a ‘wait and see’ approach. Thus, we maintain our forecast for the cash rate to stay at the current record low until 2Q12. By then, there should be conclusive evidence that the earthquake reconstruction phase is in full-swing, that the domestic economy is standing on its own two feet, and that above trend growth (as of 1Q12 on our forecast) will be reducing the excess capacity in the economy.

In the very short statement that accompanied the OCR announcement this morning, the Governor said that the outlook for the New Zealand economy remained “very uncertain” following the earthquake in Christchurch (Feb. 22). In the wake of the tremors, indicators of confidence, spending, and tourism had declined sharply, although had since shown signs of recovery. That said, the RBNZ highlighted that activity outside Christchurch appeared “relatively unaffected”. Indeed, on a positive note, with respect to the broader economy, the RBNZ acknowledged that housing market turnover and business investment had begun to increase, that trading partner growth remained robust, and commodity prices high. On the other hand, however, higher oil prices and elevated NZD were having a dampening effect on activity.

Our forecast is for economic growth to accelerate gradually throughout the year, although growth will be coming from an extremely low base, meaning that it will take some time before the excess capacity in the economy is absorbed. Indeed, even prior to the February earthquake, the economy had underperformed, mainly owing to efforts by households to reduce debt. While there had been some signs that the economy was beginning to recover early in 2011, these were more than offset by the Christchurch earthquake; post-quake, the economy likely will have contracted in 1Q.

The Governor appeared comfortable with the inflation outlook. Although at present “headline inflation is currently being boosted by recent increases in indirect taxes”, the RBNZ expects that annual inflation will “settle comfortably within the target band” of 1%-3% once these tax increases drop out of the annual rate. This should be in 4Q11 but, until then, the RBNZ will be concerned that higher headline inflation (currently at an elevated 4.5%oya) could influence price- and wage-setting behaviour.

Indeed, the RBNZ already has acknowledged there could be a boost to inflation from the earthquakes. The worry for the Bank will be the possibility that these price rises could lead to second round effects. The main risks, therefore, is that higher prices could start to flow through into higher inflation expectations. The RBNZ would then be forced to remove the current stimulus sooner than we now predict. For now, though, core inflation remains benign and inflation expectations anchored. Providing this remains the case, we believe the RBNZ will remain comfortably sidelined throughout 2011.

HSBC chief economist Paul Bloxham

As always, the post-decision statement was short, so there is little gristle to chew on. The main gist of the statement was largely as expected and does not change our view that the next rate rise is likely to be in Q4. From the RBNZ's perspective there is no need to hint at the timing of the next rate rise, as it is widely understood to be some time away. 

One area that differed from our expectation was just how sanguine the RBNZ seems about the outlook for inflation. The Governor did mention some concerns about oil prices, but also pointed out that the OCR level was appropriate because the outlook for 'core' inflation was for a return to target. They seem content to attribute the current high level of CPI inflation (0.8% q-o-q and 4.5% y-o-y) entirely to the effect of last year's tax changes. 

Another area of interest was the Governor's concern about the high level of the NZD. The exchange rate is currently at a high level against the USD, trading around 81 cents, though on a trade-weighted basis it is still below its highs of 2010, which is an indication of the extent to which it reflects USD weakness rather than NZD strength. Nonetheless, the Governor's comments are likely to fuel further debate about the level at which the RBNZ might become uncomfortable with the exchange rate, and their appetite to intervene. 

Bottom Line

The OCR was left unchanged at 2.50%.  The post-decision statement had few surprises and suggested little about the timing of a return of rates towards normal.  We still expect economic conditions to warrant a rate rise in Q4.

(Updated with BNZ reaction, HSBC reaction, JP Morgan reaction, previous Bollard comments on currency, link to Nat Bank Business Outlook, Aussie inflation, Westpac reaction, NZ$ reaction, ASB economist comment, chart)