With fears of a second major financial crisis remaining 'unacceptably high', ASB economists see OCR on hold at 2.5% next Thursday

The Reserve Bank is likely to leave the official Cash Rate (OCR) unchanged at 2.5% at its review next Thursday, ASB's economists say, with uncertainty surrounding the global economic outlook - dominated by the European sovereign debt crisis - the key factor in the central bank's decision.

"The risk the Eurozone situation could deteriorate and spark a second major financial crisis remains unacceptably high," say ASB economists Nick Tuffley, Christina Leung and Jane Turner in an OCR preview note.

"In addition, the Reserve Bank will be wary of continued theatrics from American politicians as the US debt ceiling issue returns to focus later this year."

On top of this Tuffley, Leung and Turner say domestic economic developments haven't been especially rosy in recent weeks, with economic growth up a less than expected 0.1% in the June quarter, and indicators highlighting a still‐fragile economic recovery. These include last week's profit warning from Fletcher Building, New Zealand's biggest sharemarket listed company, due to weak residential construction and delays in the rebuild of Christchurch as aftershocks continue.

"Overall, there is no urgency for the Reserve Bank to increase interest rates in the coming months. The Reserve Bank will remain on the sidelines until confidence in Europe returns," ASB's economists say.

"Assuming some resolution is found in the coming months, we expect the Reserve Bank to lift the OCR by 25 basis points in March, and at each consecutive meeting bringing the OCR to a peak of 4%."

In its last OCR review, on September 15, the Reserve Bank left the OCR at 2.5% with Governor Alan Bollard saying if recent global developments had only a mild impact on the New Zealand economy, it was likely the OCR would need to increase. The central bank cut the OCR by 50 basis points to 2.5% on March 10, after the devastating February 22 Christchurch earthquake which killed 181 people, with Bollard describing the cut as an insurance measure.

Bleaker picture since September

ASB's economists note that since September the global economic outlook has deteriorated.

"Forecasts for (New Zealand) trading partner growth have been revised down steadily in recent months. Further, the revisions are no longer isolated to US, UK and Europe, with forecasters becoming more wary of the flow‐on impacts to economic activity in developing Asia. In addition, large downside risks to the outlook remain as the Eurozone sovereign debt crisis has yet to be resolved," they say.

"The risks to the global outlook stemming from the Eurozone sovereign debt crisis remain unacceptably high, and will keep the Reserve Bank on the sidelines until March next year."

Next Thursday's Reserve Bank OCR decision will closely follow a European Union summit this weekend, which German Chancellor Angela Merkel has already warned won't be “the end point” of the debt crisis, which she says requires more than “a magic wand” to solve.

The OCR review also comes hot on the heels of the Rugby World Cup, with the tournament concluding in Auckland on Sunday night with the final between the All Blacks and France. The Reserve Bank has predicted the tournament will attract 95,000 overseas visitors, with them spending NZ$700 million.

Funding cost concerns

Meanwhile, ASB's economists note that one of the Reserve Bank's key concerns in its September OCR review was a potential rise in funding costs for New Zealand's major banks, who source about one-third of their funding from overseas, if the European crisis drags on. However, ANZ New Zealand raised 500 million euros (about NZ$868 million) from European institutional investors in a covered bond issue last week, which was priced at 95 basis points over the euro interest rate swap rate.

In the US ASB's economists note the political environment remains concerning, with the Reserve Bank wary that the "debt ceiling debacle" isn't yet over. In November, a bipartisan US congressional committee tasked with finding US$1.5 trillion of further deficit reductions is due to report back. If the committee fails to reach an agreement or its proposal is rejected, then US$1.2 trillion in spending cuts will be automatically triggered, drawn equally from domestic spending and defence.

"These automatic spending cuts would be very damaging the US economy, raising the chances of a double‐dip recession over 2012," Tuffley, Leung and Turner say.

"Overall, a large degree of uncertainty around the global economic outlook remains, although this is mostly a result of political dithering. At this stage, the Reserve Bank cannot rule out a second financial crisis triggered by a nasty turn in the Eurozone sovereign debt crisis."

Domestic indicators not strong

Meanwhile, a weaker New Zealand dollar since early August is providing "a helpful buffer" against the heightened uncertainty.

Domestically the 0.1% second quarter GDP growth was much weaker than the 0.6% expected by the Reserve Bank. Inflation indicators suggest underlying inflation pressures are contained for now. Other domestic indicators suggest demand from households remains lacklustre with house sales plateauing in more recent months. And despite business confidence and consumer confidence proving relatively resilient, credit growth remains weak suggesting businesses and households remain cautious, ASB's economists say.

"Given the likelihood of ongoing global uncertainty and increased New Zealand household sensitivity to interest rate increases, the risk is the increases in the OCR will be more drawn out, with the RBNZ pausing at some point along the way."