Reserve Bank keeps OCR on hold at 2.5%; slashes projected interest rate track; Hits out at high NZ dollar

By Alex Tarrant

The Reserve Bank of New Zealand has left the Official Cash Rate on hold at 2.5%, but considerably cut its projected future interest rate track, saying the high New Zealand dollar is helping contain inflation.

But in its March quarter Monetary Policy Statement (MPS), the Bank also took a swipe at the level of the currency, which had risen 7% on a Trade Weighted basis since its December MPS. The high currency was detrimental to the tradable sector, undermined GDP growth and inhibited economic rebalancing, the RBNZ said.

If the New Zealand dollar sustained its strength, there would be less need for future increases in the OCR, the RBNZ said. It is projecting a slight depreciation of the New Zealand dollar over the next three years.

If that depreciation occurred, the Reserve Bank said it expected to have to increase the Official Cash Rate “modestly” over the forecast horizon to March 2015.

Reserve Bank projections suggest the first increase in the OCR may come through the September 2012 to March 2013 quarters, which has been pushed out from the June 2012 quarter projection in the December MPS.

Its projected track for the 90-day bank bill rate was cut as much as 70 basis points from its December forecasts. The RBNZ now shows it hitting a peak of 3.6% in the March 2015 quarter, suggesting an OCR peak near 3.25% in the projected period to March 2015.

The December quarter MPS suggested a 90-day peak of 4% in the March 2014 quarter, meaning the peak forecast in its projected period has been cut 40 basis points. The RBNZ now sees the 90 day bill rate at 3.3% by March 2014, down 70 basis points from its December forecast.

The 90-day rate generally sits about 25-30 basis points above the OCR.

'Lower for longer'

This suggests floating mortgage rates may stay ‘lower for longer’ as they move closely in tune to movements in the Official Cash Rate. Longer-term fixed mortgage rates, which are influenced by wholesale swap rates and inflation expectations have been falling in recent months.

Before today’s announcement, markets had been pricing in the first OCR hike in December this year.

Reserve Bank Governor Alan Bollard said inflation had settled near the middle of the Bank’s 1-3% target range, and that inflation expectations had fallen.

“The domestic economy is showing signs of recovery. Household spending appears to have picked up over the past few months and a recovery in building activity appears to be underway. That recovery will strengthen as repairs and reconstruction in Canterbury pick up later in the year,” Bollard said in a media release on the OCR decision.

“High export commodity prices are also helping to support a continuing recovery in domestic activity,” Bollard said.

“Policy actions from a number of central banks have boosted global confidence.  While encouraging, financial market sentiment remains fragile and risks to the global outlook remain.  Furthermore, the easing in global monetary policy and resultant recovery in risk appetite has contributed to a marked appreciation in the New Zealand dollar,” he said.

High NZ$ undermines tradable sector

“While helping contain inflation, the high value of the New Zealand dollar is detrimental to the tradable sector, undermines GDP growth and inhibits rebalancing in the New Zealand economy.  Sustained strength in the New Zealand dollar would reduce the need for future increases in the OCR.

“Given the medium-term outlook for inflation, it remains prudent to hold the OCR at 2.5 percent,” Bollard said.

The recent appreciation in the exchange rate would likely dampen imported inflation in 2012. Offsetting this was increases in international oil prices over the past month, driven by tensions in the Middle East. The Bank’s projections assumed oil prices would “moderate soon”.

The risk of significant near-term deterioration in global economic conditions had moderated since the December MPS, the Reserve Bank said.

The European Central Bank’s long-term refinancing operation (LTRO), where the ECB provided cheap credit to the European financial system, had provided the largest boost to confidence. The Greek rescue package and lower interest rates in Europe also helped.

Meanwhile, the Bank of England and Bank of Japan had extended their quantitative easing programmes, and the US Fed had extended its expectation to keep official rates in the US near zero. Monetary policy easing in Australia and China also had an effect.

“These policy measures have substantially improved market sentiment,” the RBNZ said.

However, this had contributed to the marked appreciation in the New Zealand dollar.

“This appreciation is likely to place further downward pressure on inflation, lowering the outlook for the OCR relative to the December projection,” the RBNZ said in the MPS.

Economists react

ASB's Nick Tuffley

The RBNZ was more dovish in this statement.  Tail risks from Europe have reduced.  However the resultant improvement in market sentiment has pushed the NZ dollar back up and given the RBNZ a new problem.

The RBNZ gave the rise in the NZ dollar a lot of prominence, writing several times that its high level was “detrimental” to the export sector in a clear signal to the market.  The risk skew the RBNZ focused on was that continued strength (that the RBNZ doesn’t see as justified) would delay OCR increases even further relative to its latest expectations.  The RBNZ is clearly unhappy with the recent lift in the NZ dollar, and future movements look like they will be front-of-mind.

Another key factor is that inflation expectations and actual inflation have fallen faster than the RBNZ had anticipated.  In fact, newswire headlines from the media conference quote Dr Bollard as saying he could actually cut interest rates if inflation expectations fell further.

We continue to expect the RBNZ will wait until December before first raising the OCR, a view that the RBNZ’s forecasts now also imply.  Our currency view is, however, stronger than the RBNZ’s.  Consequently we have slightly spaced out our view of the pace of the first few hikes: we now expect OCR increases at Monetary Policy Statements (every second window) instead of the first few being consecutive.  However, we still expect medium-term inflation pressures will be slightly stronger than the RBNZ does, and continue to forecast an eventual 4% OCR peak (with the RBNZ forecasts now implying a peak of 3.25% - 3.5%).  The MPS release reinforces that the RBNZ is in no hurry to lift interest rates in the short term.  The risks remain skewed to a later start, however, with both the NZD and near-term inflation developments elevated as key watch factors.

The NZD immediately dropped following the announcement (which was clearly targeted at lowering the NZD), with the NZD/USD returning to yesterday’s lows of 0.8160 and the NZD/AUD falling back to 0.77.  Interest rates eased back slightly, with swap yields down 3-5 basis points with the long end outperforming. 

Westpac's Dominick Stephens

The RBNZ kept the OCR unchanged at 2.5% as expected. The accompanying statement was bullish on growth, but dovish on inflation. Consequently, the outlook for 90-day rates was softened materially. The RBNZ still appears to be signalling an OCR hike around the end of this year. But beyond that, the interest rate forecast rises at a pace of only one OCR hike per year.

The RBNZ recognised improvements in the local economy with "The domestic economy is showing signs of recovery. Household spending appears to have picked up... and a recovery in building activity appears to be underway. That recovery will strengthen as repairs and reconstruction in Canterbury pick up later in the year." Their GDP growth  forecasts were strong - 3.1% in the year to March 2013, and 3.7% in the year to March 2014.

They were cautiously constructive on the global situation with comments about stronger global confidence but market sentiment remaining fragile.

Despite that, the RBNZ was very sanguine on the inflation outlook. The key here is the RBNZ's projection for the TWI to remain very high for a long time - hanging around 72 until the end of 2013. The RBNZ feels that this will be "detrimental to the tradable sector", and by keeping the price of traded goods and services low, will help keep inflation below 2% until 2014, thus reducing "the need for future increases in the OCR".

The RBNZ is telling a consistent story, but we feel it will be a tough sell for markets. Monetary policy has been here before. Back in 2003 the RBNZ eschewed responding to the improving domestic economy for fear of further stoking an overvalued exchange rate. In the end, rising house prices fuelled domestic inflation and the OCR ended up going much higher than markets or the RBNZ anticipated.

We continue to believe that an extended series of OCR hikes will be necessary to reign in domestic inflationary pressures arising from the Canterbury rebuild, even in the face of a strong exchange rate.

We foreshadowed a dovish statement, on the basis of low inflation and the high exchange rate. But this was even more dovish than our expectation, and was certainly a surprise to markets. The exchange rate fell 40 pips, and 2-year swaps fell 4bp.

First NZ's Chris Green

The key change in tone in the RBNZ's policy assessment has been the increased emphasis on the impact of the elevated NZ dollar potentially undermining GDP growth, inhibiting the rebalancing of the NZ economy and dampening inflationary pressures. Moreover, the RBNZ notes that the "sustained strength in the NZ dollar would reduce the need for future increases in the OCR".

This comment, together with the projected later start and more gradual tightening profile from the RBNZ presented in the March 2012 MPS, can be expected to result in market expectations shifting slightly towards a lower for longer domestic interest rate profile. As such, the recent market expectation for a December 2012 quarter timing for the RBNZ to initiate an increase in the OCR is now likely to be move into early  2013.

On the whole, reflecting the presentation from the RBNZ of a lower for longer domestic interest rate profile, set against a potential backdrop of easier global interest rate settings, reinforces our expectation that the RBNZ is likely wait until the March 2013 MPS before raising the OCR by 25bps to 2.75%.

JP Morgan's Ben Jarman

The policy statement makes clear that strong NZD is undesirable because it impedes the structural adjustments that have to occur if New Zealand is to rebalance by using the export sector to repair national balance sheet. The fact that NZD appreciation has occurred while export prices have moved sideways similarly was described today as a “dislocation”.

Having persistently held above levels we feel are consistent with New Zealand’s home-grown risks from ongoing seismic activity and the requirement of deep balance sheet adjustments (both of which see little relief from a modestly better global backdrop), the Kiwi now looks a little less resilient. The currency has dropped a few cents against USD since the RBNZ;s forecasts were finalized, and is down further following today’s announcement. The fact that the Bank has marked to market the prior strength in the currency to such an extent, and lowered the 90 day rate tracking markedly, may propagate this move, in that the forecast changes lend credibility to the jawboning exercise: if officials really believe the TWI projections, there obviously is little need to do much with interest rates.

The outlook for rates will therefore be more contingent than usual on where the currency settles in the near-term. Unless the moderating trend in NZD continues, the risks are to a later move than our forecast of a September rate hike.

(Updated with economist reaction from ASB's Nick Tuffley, Westpac's Dominick Stephens, JP Morgan's Ben Jarman and First NZ's Chris Green, NZ$ and wholesale interest rate falls)