Reserve Bank leaves Official Cash Rate on hold at 2.5%; says euro risk remains; expects inflation to sit near 2% over medium term

By Alex Tarrant

The Reserve Bank has left the Official Cash Rate on hold at 2.5%, and signalled no change to its forecast interest rate track.

It said there was still a limited risk of a very significant deterioration in the euro area.

It also changed the wording in its June statement that, "it remains appropriate for monetary policy to remain stimulatory, with the OCR being held at 2.5 percent," to this morning saying instead just that, "it remains appropriate for the OCR to be held at 2.5%."

In New Zealand, housing market activity was increasing as forecast. However, the Bank noted fiscal consolidation - ie debt repayment - and the level of the exchange rate were constraining growth in the demand side of the economy, implying that it still views the New Zealand dollar as overvalued.

ASB chief econmist Nick Tuffley noted New Zealand's Trade Weighted Index, a basket of currencies of our major trading partners watched by the Reserve Bank, was currently above the Bank's June projection.

"The RBNZ will likely be mindful of its effects on export commodity returns over the coming year. This is particularly in light of the continued easing in global commodity prices more recently," Tuffley said.

Euro risks remain

Releasing the central bank's latest six-weekly OCR decision, Reserve Bank Governor Alan Bollard said New Zealand's economic outlook remained consistent with that described in the June Monetary Policy Statement (MPS).

Forecasts in the June MPS pointed to a resumption of OCR hikes in mid-2013, going by the Bank's 90-day interest rate track.

New Zealand bank economists are split between March and June/July 2013 for the next move in the OCR. Independent forecasters Infometrics are picking mid 2013, while NZIER economists say the OCR could be on hold to 2014, if not cut before then.

"New Zealand's trading partner outlook remains poor, with several euro-area economies in recession," Bollard said in a statement.

"There remains a limited risk that conditions in the euro area deteriorate very significantly. The Bank continues to monitor the situation carefully given the potential for rapid change," Bollard said.

Debt repayment, high NZ$ constraining growth

Domestically, Bollard said the Bank continued to expect economic activity to grow modestly over the next few years.

"Housing market activity continues to increase as forecast, and repairs and reconstruction in Canterbury are expected to further boost the construction sector," Bollard said.

"Offsetting this, fiscal consolidation and the exchange rate are constraining demand growth," he said.

"Underlying annual inflation, which recently moved below 2%, is expected to settle near the mid-point of the [1-3%] target range over the medium term.

"It remains appropriate for the OCR to be held at 2.5%."

Annual CPI inflation fell to 1% in the year to the June 2012 quarter, its lowest level since 1999. Excluding a hike in cigarette excise tax, the CPI would have risen 0.6%, Stats NZ said.

See our coverage of the Reserve Bank's June Monetary Policy Statement through the links below:

RBNZ holds OCR at 2.5%; lowers forecast 90 day bill rate track; implies OCR flat til June 2013 and rising just 60 bps by end 2014

Reserve Bank canvasses effects of major European downturn, Greece leaving eurozone

RBNZ bemoans lack of investment, says has cut NZ’s potential growth rate; Capacity tight

Reactions

Westpac

The Reserve Bank has held the OCR at 2.50%, and repeated that it remains "appropriate" to leave it there. 

The short media release was probably most notable for how little it had evolved since June.  The result was a slightly less dovish slant than we or the markets were expecting. 

The release noted that "New Zealand’s economic outlook remains consistent with that described in the June Monetary Policy Statement".  Global growth has softened and the European situation remains hazardous, but a 'muddle through' remains the RBNZ's central view. 

Domestic activity is expected to pick up, aided by post-quake reconstruction in Canterbury.  Against this, fiscal belt-tightening was again cited as a constraint on growth, joined this time by the high exchange rate - though this was a much more modest acknowledgement of the NZ dollar's strength than we were expecting. 

Similarly, the recent drop in CPI inflation - with the headline rate falling to its lowest in 13 years - was treated in a fairly anodyne manner: "Underlying annual inflation, which recently moved below 2 percent, is expected to settle near the mid-point of the target range over the medium term." 

The June MPS projections, suggesting that the first OCR hike would remain on hold until around mid-2013, appear to be intact.  We continue to expect the first OCR in July 2013. 

Market implications
Markets were expecting a slight dovish shift, so this statement is therefore slightly positive for the NZD and NZ swap yields. 

NZD/USD could extend last night's rally further to 0.7930 on this. The 2yr swap yield could rise to 2.60% (for a total reaction worth 5bp). The 2-10yr swap curve may flatten from 97.5bp to 95bp.

ASB

RBNZ keeps the OCR on hold, with no surprises in the statement.  We continue to expect the first OCR increase to occur in March 2013, with risks still skewed by Europe to a later start.

Growth: little change

As expected, the RBNZ noted there has been little change to its economic outlook since the June MPS. The RBNZ highlights the continued improvement in housing market activity, which has evolved broadly in line with its forecast, and its expectation that that post-earthquake rebuilding activity will boost construction activity over the coming years.  Recent construction and consent issuance data indicate rebuilding is underway, and we expect that as this gains further momentum later this year this will underpin a recovery in construction activity. 

The RBNZ also notes its expectation fiscal consolidation and the high NZ dollar will weigh on domestic demand over the coming year. The NZD TWI currently sits at above the RBNZ’s June MPS projection, and the RBNZ will likely be mindful of its effects on export commodity returns over the coming year. This is particularly in light of the continued easing in global commodity prices more recently.

International: Europe a “limited” risk of significant deterioration

Once again, the RBNZ highlights the situation in Europe, noting that several economies there are in recession and, more generally, "New Zealand's trading partner outlook remains poor." The risk of a significant deterioration in Europe is now described as "limited", as opposed to "small but growing" in the June statement. That suggests that the RBNZ sees the risks as having stabilised somewhat, possibly in light of the conclusive outcome of the Greek election a few days after the June statement. Overall, offshore risks will clearly continue to dominate the near-term outlook for monetary policy, with the RBNZ "monitoring euro-area developments carefully." A significant deterioration would most likely prompt a cut to the OCR.

Inflation: still relaxed

The RBNZ remains relaxed on the inflation front and continues to project inflation settling near the mid-point of the target range in the medium term.  We still see upside risk to this medium-term projection.  We see limited spare capacity in the economy, and expect inflation pressures will quickly re-emerge over 2013 and 2014 as the underlying economy recovers and the Canterbury rebuild commences.  However, for the time being, the subdued Q2 inflation result highlights the lack of urgency for policy action in the near term and provides the RBNZ plenty of time to observe Eurozone developments.

Implications

There are few fresh implications from the latest statement – the opening paragraph of “…remains consistent with …June Monetary Policy Statement” said it all.  Greece has pulled back from the brink of triggering disruption, but Spain’s situation has become more fragile.  Meanwhile, the domestic economy has held up.  The RBNZ has, however, shifted its emphasis on the NZ dollar from falls helping cushion export earnings to it being a growth headwind.

We see the NZ economy generating a greater degree of inflation pressure than the RBNZ currently anticipates as the recovery progresses.  Consequently, we expect the OCR will eventually rise further than the RBNZ’s forecasts imply, to an eventual peak of 4% in mid 2014.  We still see some risk that the RBNZ will lift the OCR slightly sooner than the 2013Q2 timing its forecasts imply.  That timing remains uncertain given the fluidity of Europe’s situation.  Over time, signs of looming inflation pressures will become more tangible and Europe’s situation less precarious, and the inflation outlook will dominate.  March is still the earliest we see the RBNZ lifting the OCR, with Europe skewing the risks to a later start.

Market reaction

The tone of the Statement was in line with expectations, and there has been no significant market reaction.  The NZD/USD lifted fractionally from 0.7890 to 0.7908 while the NZD/AUD moved from 0.7650 to 0.7662.  Interest rate markets have removed some pricing of rate cuts in future meetings, which is seeing short-term interest rates lift a few basis points.

JP Morgan (Australia)

Relative to the RBNZ’s April policy decision, where NZD strength had seen the RBNZ Governor flirting with the idea of easing policy, today’s announcement was disappointingly bland. With the currency having rallied fairly consistently since mid-May to back near its old highs on a TWI basis, the April statement - in which the Bank saw the stifling currency backdrop as a possible catalyst to “reassess the outlook for monetary policy settings” - looked like it would be a convenient enough template to spin out again.

In the event though, the only acknowledgement in today’s decision that currency strength is spilling into monetary policy decisions came through the Governor dropping his depiction of the 2.5% OCR as being “stimulatory”. As in June’s MPS though, current settings still are described as “appropriate”.

While jawboning the currency certainly is not a foreign concept to the Governor, those efforts have frequently stopped short of pursuing an explicit easing bias. We suspect part of that reluctance today is due to the Gubernatorial transition that looms after September’s MPS, which argues for a steady hand on policy near-term. In particular, having treated the 2.50% threshold in rates as sacrosanct throughout earthquakes and global financial crises, suddenly lobbing in an easing bias just before the new Governor arrives, in order to pull the currency down, probably would be viewed by markets for what it is: a non-credible threat. For that reason, and given previous behavior, it’s hard to see what would get the RBNZ over the line to cut rates in the near-term, absent calamity in Europe.

Rather, the softer tones on growth prospects today seem more consistent with low for long policy settings. Trading partner growth was described as “poor”. On the domestic front, there was acknowledgement that while the recovery in the housing market and construction sector are playing to script, that impulse may no longer be expected to deliver as much upside to growth, given the offsetting drags of currency strength and fiscal consolidation. Overall, activity is expected to grow only “modestly” over the next few years.

Our current forecasts have the RBNZ raising rates in March 2013. That is still quite a way off, but the Bank’s fading optimism in terms of long run growth catalysts means the risks are tilting to a later and more gradual normalization path.

ANZ

The RBNZ left the OCR unchanged at 2.5 percent.  The policy statement was concise and to the point with clear neutral nuances.

The hurdle to prospective OCR moves remains high, with the statement providing little indication of the timetable for OCR hikes.

Developments in Europe remain at the core of the RBNZ’s thinking, with the RBNZ noting that the trading partner outlook remains poor. While a significant deterioration in the global outlook would strengthen the case for OCR cuts, the inference from the RBNZ is that the risk of this remains limited. 

There was little mention of the high NZD, short of the comment that it was constraining demand growth.  The upshot is that the high NZD on its own will not be sufficient to see OCR cuts, but it is likely to enable the OCR to remain on hold for longer.

Comments on the domestic economy suggest that the low OCR is providing economic support. The RBNZ noted that the foreshadowed recovery in the housing market was evolving in line with their forecasts, with the Canterbury rebuild expected to provide a further boost to construction sector activity.

We infer from the fact inflation is expected to settle around the middle of the band that a) the RBNZ is very relaxed and b) a mild tightening bias remains behind the scenes. 

The bottom line: the OCR looks set to stay at 2.5 percent for an extended period, bar a global meltdown.  We do not foresee any need for the OCR to move up before the middle of 2013 at the earliest.

BNZ

The Reserve Bank kept things nice and steady, and concise, at today’s OCR Review. This was very much as we hoped and expected. While holding the policy rate at 2.50% Governor Alan Bollard essentially reiterated the basics of the June Monetary Policy Statement (MPS). Global risks are being monitored carefully, as they should be. However, the Bank also maintained its view of ongoing domestic recovery and progression, supported by the outlook for construction. 

Yes, there was a lot more our central bankers could have talked about today. But to no real net effect regards monetary policy. The fact is that there are as many domestic positives as there are global negatives out there. In any case, the (interim) OCR Reviews are not the time to be shooting the breeze. Such things are best left to the fullness of quarterly Monetary Policy Statements (and their associated press conferences these days). The next one of these is due 13 September, Bollard’s last.   

Even in what little the RBNZ did say today, it was most interesting in what it therefore didn’t. 

For example, the Bank didn’t make too much of the high NZ dollar, even though the trade-weighted index is a few per cent stronger than the June MPS anticipated (having increased about a fifth of a US cent between 9 and 10am today). And instead of trying to make valuation judgements, Bollard simply said the exchange rate was “constraining demand growth.” Perhaps the Bank is becoming more accepting of the view the currency’s fair value is difficult to be definitive on – especially amid still-high terms of trade – and is flexible enough in any case to adjust to economic reality and risks? 

The Bank also described “fiscal consolidation” as constraining demand growth, while leaving it at that. Of course, if we were a European country this issue would need a lot more explanation. 

Note also that the Bank did not explicitly reference the recently slow headline Q2 CPI result, which, at an annual 1%, actually hit the bottom of the 1.0 to 3.0% target band. Instead, it talked in terms of underlying inflation that is  “expected to settle near the mid-point of the target range over the medium term.” This is a wise approach, at a time when some people might be getting excited about inflation going too low. We still forecast higher CPI inflation than the RBNZ does over the next year or two. 

Nor did the Bank draw attention to the fact Q1 GDP (following revisions to earlier data) proved about 1% stronger than it had in its June MPS. We believe part of this relates to some “technical” issues in the 1.1% Q1 GDP expansion, which might reverse out in Q2. So, the Bank would prefer to wait for Q2 GDP before accepting this measure of the economy is clearly stronger than it appreciated. For the record, while we acknowledge the technical issues around Q1 GDP growth, we are also still picking a reasonable follow-on for Q2 growth, of 0.4%. 

So, for all it did, and didn’t say, today, we thought the Bank’s OCR commentary today was a very good one. The risk was that Bollard might sound nervous and edgy again, over-exciting the market for yet more easing. We hoped this wouldn’t be the case. And it wasn’t, at all. 

Of course, the market still has a difficult job to do in positioning for, in the words of the RBNZ, “a limited risk that conditions in the euro area deteriorate very significantly.” For this reason we can understand the slight reduction the NZ wholesale interest rate curve has for the NZ OCR ahead. That is, still about -15bps or so over the next 12 months (following scant reaction to this morning’s OCR review). But this doesn’t mean things will be a yawn from here. Global issues remain a demonstrable negative. Yet, barring a global meltdown, domestic forces retain the potential to surprise on the strong side, in our view, particularly regards inflation.