OCR on hold at 2.5%; Reserve Bank indicates ‘lower for longer’ bias if NZ$ stays high and other settings don’t change

The Reserve Bank has left the Official Cash Rate (OCR) on hold at 2.5%, and indicated if the New Zealand dollar remained elevated without other economic settings changing, it would need to reassess where it thought interest rates were headed.

The decision to leave the OCR on hold was in line with market expectations. Most economists are picking the first move up in the OCR from its current level will be no earlier than December this year. The New Zealand dollar rose following the 9am release, from 81.25 US cents just before 9am, to 81.75 US cents at 9:15am, and was at 81.65 US cents at 9:30am.

The Reserve Bank fired another shot across the bow of the high New Zealand dollar, saying if the exchange rate were to stay strong, without “anything else” changing, it would need to “reassess the outlook for monetary policy settings.”

In its March 8 Monetary Policy Statement (MPS), the Reserve Bank’s latest set of public forecasts, the Bank forecast the 90-day bank bill interest rate would rise from 2.8% in the March 2012 quarter to 3.1% in the March 2013 quarter, indicating the OCR would be 25 basis points higher – 2.75% - at this time.

The MPS forecast the 90-day track to then rise to 3.6% by the March 2015 quarter, suggesting an OCR of 3.25% at that time.

Lower for longer; Possible cuts?

The latest comments now suggest a ‘lower for longer’ bias than was indicated in the March MPS, but only if the currency remains strong and other economic settings, like domestic activity or commodity prices, do not change.

Following the decision, bank economists jumped on Bollard's comments on the exchange rate.

Westpac chief economist Dominick Stephens said it was telling that, while the Reserve Bank's March statement had said "sustained strength in the New Zealand dollar would reduce the need for future increases in the OCR", today's statement made no reference at all to the next move being up.

"The key statement was: 'Should the exchange rate remain strong without anything else changing, the Bank would need to reassess the outlook for monetary policy settings,'" Stephens said.

"Given that the 'outlook' in March was for little more than one 25bp OCR hike a year over the next three years, any meaningful change to the outlook as a result of the strong exchange rate would likely have the RBNZ projecting rate cuts," he said.

Stephens said Westpac believed exchange rate intervention was now on the cards, given that all four of the RBNZ's pre-conditions for intervention had been met. However, "the main argument against intervention is that the Prime Minister recently commented that it would be ineffective," he said.

ANZ chief economist Cameron Bagrie said he did not think intervention was on the cards.

ANZ considered Bollard's comment on the currency "to be largely sabre rattling."

"We view the hurdle to an OCR cut as high. While we can understand the RBNZ’s frustration, cutting the OCR in response to currency strength is a dangerous game when the domestic economy is recovering," Bagrie said.

"We believe a cut would require a domestic slowdown due to the tradable sector deteriorating severely as a consequence of a sharply worse global economic outlook. This remains a non-trivial risk, though is not our central view," he said.

ASB economist Nick Tuffley said Bollard's exchange rate comment today "was a more official version of comments the Governor made to media after the release of the March Monetary Policy Statement. A persistently higher than factored exchange rate, with all other things constant, would imply interest rates either on hold for longer or even lower for the same inflation outcome."

"Clearly that concern [that the NZ dollar is overvalued] remains, with the statement saying that "should the exchange rate remain strong without anything else changing, the Bank would need to reassess the outlook for monetary policy." However, we are of the view that, for now, this is language aimed at lowering the exchange rate and any policy response remains contingent on the strong currency filtering through to inflation outcomes in the wider economy," Tuffley said.

NZ economy recovering

The domestic economy was recovering, with housing market activity increasing and a recovery in building work, the Reserve Bank said. However, global market sentiment was still fragile.

“Inflation is restrained and is expected to stay near the middle of the Bank’s target range,” Reserve Bank Governor Alan Bollard said in a media release on Thursday morning.

The latest Consumers Price Index inflation reading for the March quarter came in lower than the Reserve Bank had expected. Quarterly CPI inflation was 0.5% in the March quarter, according to Statistics New Zealand. The Reserve Bank had been expecting a 0.7% reading. Annual CPI inflation in the March quarter was 1.6%. The Reserve Bank is tasked with keeping annual medium-term CPI inflation within a 1-3% target band.

“The domestic economy is showing signs of recovery. Housing market activity continues to increase and a recovery in building activity appears to be underway, as forecast. That recovery will strengthen as repairs and reconstruction in Canterbury pick up later in the year,” Bollard said.

“However, the global outlook remains of concern. Near-term indicators have moderated and financial market sentiment is still fragile.

“The New Zealand dollar has stayed elevated despite recent falls in commodity prices. Should the exchange rate remain strong without anything else changing, the Bank would need to reassess the outlook for monetary policy settings,” Bollard said.

“For now, it is appropriate for the OCR to remain at 2.5 percent,” he said.

Economist reaction

ASB chief economist Nick Tuffley:

Growth

The RBNZ acknowledged the recent improvement in domestic economic activity, particularly in the housing market. In noting the recent pick-up in building activity, the RBNZ appears to be more confident about the timing of the post-earthquake rebuilding.  The RBNZ expects repairs and reconstruction will gather momentum over late 2012 and boost activity in the NZ economy, in line with our forecasts.  Recent activity indicators point to a continued gradual recovery in the NZ economy taking place.  In regards to commodity prices, the RBNZ highlights the recent declines, but the concern appears to be more with the continued strength in the NZ dollar.

The RBNZ continued to note the downside risks from the global growth outlook. Recent activity indicators in the major economies have been mixed, with signs of a slowing in the recovery in manufacturing activity globally. Added to that, the political uncertainty in Europe is a reminder that the European debt crisis is far from over, and challenges remain for European governments in implementing austerity measures. Nonetheless, the outlook for global growth is marginally improving, and the IMF recently revised up its forecasts for 2012 and 2013 although downside risks continued to be noted.

Inflation

The RBNZ had very little say on inflation, which is unsurprising given recent developments.  All indicators point to inflation remaining very subdued over 2012.  The RBNZ expects inflation to remain in the middle of the target range (1-3%).  We expect near-term inflation to be weaker than the RBNZ forecast in the March Monetary Policy Statement, largely given our view for a higher NZD.  However, from 2013 we expect underlying inflation pressures to pick up swiftly.  We continue to believe the RBNZ is underestimating medium-term non-tradable inflation pressures.  However, for the time being, the RBNZ has time on its side as near-term downside risks dominate.

NZ dollar causing concern again

As expected, the RBNZ noted that the exchange rate has stayed at more or less the same level as at the March MPS - a level that the RBNZ felt was unjustified by domestic fundamentals and was damaging to the export sector. Clearly that concern remains, with the statement saying that "should the exchange rate remain strong without anything else changing, the Bank would need to reassess the outlook for monetary policy." However, we are of the view that, for now, this is language aimed at lowering the exchange rate and any policy response remains contingent on the strong currency filtering through to inflation outcomes in the wider economy.

Implications

The statement was largely as expected and to the point – particularly over the NZD, the RBNZ’s biggest bugbear at present.  The key line in the statement was: “should the exchange rate remain strong without anything else changing, the Bank would need to reassess the outlook for monetary policy settings”.  This was a more official version of comments the Governor made to media after the release of the March Monetary Policy Statement.  A persistently higher than factored exchange rate, with all other things constant, would imply interest rates either on hold for longer or even lower for the same inflation outcome.

The statement certainly does reinforce the risk of a later start to OCR increases from our December expectation.  However, we are mindful that the RBNZ has a very sanguine view on inflation generated by the Canterbury earthquake rebuild, with warnings signs appearing in the latest CPI.  The housing market, in general, risks becoming more prominent on the radar.  By year-end the global outlook should also be looking healthier than at present and supporting commodity prices.  Against those inflation considerations, we also expect the NZ dollar to be higher in a year’s time than it is now.

We have held to our view that the first OCR increase will occur in December, but the risks remain skewed to a later start.  We continue to expect the eventual tightening cycle will be gradual, with OCR increases at MPS releases – i.e. every 3 months on the way to a peak of 4% in early 2014.

Market reaction

Given there were not great surprises in the statement the overall market reaction was relatively muted.  Surprisingly, FX and interest rate markets moved in opposite directions.   The NZD spiked 30 points higher against the USD following the statement.  Meanwhile, interest rates have eased 2-3 basis points lower.

Westpac chief economist Dominick Stephens:

Market implications 
As we expected, the Reserve Bank ramped up its warnings about the deleterious effects of the high New Zealand dollar in today's OCR review, going so far as to suggest that policy easing is on the table if the NZD remains unjustifiably high.  The statement made no reference to the next move in the OCR being up. The Reserve Bank is now firmly on hold, with the next move dependent on the exchange rate. 

We also regard exchange rate intervention as possible, given that all four of the RBNZ's pre-conditions have been met. The main argument against intervention is that the Prime Minister recently commented that it would be ineffective. 

The two-year swap rate fell 6bps to 2.80%.  However, the NZD rose 20pts to 0.8160.  We will elaborate on the market reaction in our bulletin later today. 

Details 
It should be noted that developments in the domestic economy were not behind the shift in the Reserve Bank's tone relative to March.  Inflation is seen as "restrained" and expected to stay near the middle of the 1-3% target range (although the MarchMPS projections saw it in the lower half of the band until late 2014).  The housing market is strengthening and building activity is picking up, as the RBNZ anticipated (bear in mind that the RBNZ's GDP growth forecasts are stronger than most private sector forecasters). 

Rather, the exchange rate was the crucial factor - specifically, the fact that it has remained elevated even as global uncertainty has risen and commodity prices have fallen.  Tellingly, while the March statement said that "sustained strength in the New Zealand dollar would reduce the need for future increases in the OCR", today's statement made no reference at all to the next move being up.  The key statement was: "Should the exchange rate remain strong without anything else changing, the Bank would need to reassess the outlook for monetary policy settings."  

Given that the 'outlook' in March was for little more than one 25bp OCR hike a year over the next three years, any meaningful change to the outlook as a result of the strong exchange rate would likely have the RBNZ projecting rate cuts. 

ANZ chief economist Cameron Bagrie:

• The RBNZ left the OCR unchanged at 2.5 percent, as universally expected. If anything, the tone was more dovish than expected.
• The tightening bias is gone from the rhetoric. Indeed, a slight easing bias can be deduced from the comment that “should the exchange rate remain strong without anything else changing, the Bank would need to reassess the outlook for monetary policy settings.” 
• However, we consider this comment to be largely sabre rattling. We view the hurdle to an OCR cut as high. While we can understand the RBNZ’s frustration, cutting the OCR in response to currency strength is a dangerous game when the domestic economy is recovering.  
• We believe a cut would require a domestic slowdown due to the tradable sector deteriorating severely as a consequence of a sharply worse global economic outlook. This remains a non-trivial risk, though is not our central view.
• Some may speculate currency intervention is possible: we don’t believe so. 
• Global concerns remain centre stage. Combined with a weaker near-term inflation and activity outlook, the RBNZ have considerable scope to stay on the sidelines. OCR hikes clearly remain such a long way off there seems little point even putting a date on it.