Westpac economists stick to view that RBNZ will be forced to drop interest rates by more than it currently intends

Westpac economists are sticking to their view that the Reserve Bank will be forced to drop interest rates by more than currently intended.

The Westpac economists are still adamant that an Official Cash Rate of 2% will be needed – though in their latest weekly commentary they have slightly shifted the predicted timing of the move.

And ASB’s economists acknowledge the RBNZ as “reluctant cutters” of interest rates. “…But we still see weak inflation pressures ahead, and the higher NZD is not going to help,” ASB senior economist Jane Turner said. 

“We now grudgingly accept the RBNZ will not cut the OCR in October.  But we still believe the weak inflation outlook does warrant lower interest rates now, and expect the stubbornly-high NZD may force the RBNZ’s hand come December.”

Turner said “rather worryingly”, the RBNZ is still holding out hope that “Princess Charming” – in the form of Janet Yellen from the US Federal Reserve will “come to rescue it from its tricky situation”.

“The RBNZ still believes that Fed hikes will lift the [US dollar].  And some eventual USD strength is probable.  But the odds are the Fed delays its rate hikes and even scales back its forecast for how much it could lift interest rates.  The USD will struggle to get much lift in this situation. And the focus on the Federal Reserve influence overlooks the fact that the [NZ dollar] is up against most of its key exchange rates.  Only a return of offshore market jitters, RBNZ rate cuts or declines in commodity prices can reverse the broader NZD rebound.  The latter influence isn’t likely to happen either.  Dairy prices have bounced off lows and reports of low dairy collections will only reinforce the dairy markets conviction of a sharp fall in NZ production this year.”

The Westpac economists say they have “long disputed” the RBNZ’s view that a lower exchange rate would return inflation to 2% on a sustained basis.

“Consequently, we have argued that only one further OCR cut will not be enough. Instead, we have been forecasting further OCR reductions, in January and March of next year, that would see the OCR fall to 2.0%.

“We remain steadfast in our view that the terminal OCR will be 2.0%. In fact, preliminary work indicates that inflation in 2016 could be even lower than we are currently forecasting – not least because the exchange rate has shot up recently.”

But the economists said that after a “Hawkish” speech by RBNZ Governor Graeme Wheeler last week, and with dairy prices and the housing market so strong, they had been forced to rethink the timing of OCR reductions in 2016. “We are now forecasting OCR reductions in March and June next year.”

They said their forecast assumes three key developments will have taken place by March: (1) An El Nino drought will have impacted agricultural production; (2) The housing market will have slowed as a consequence of mortgage lending restrictions in Auckland; and (3) Data will have made it clear that inflation is set to run closer to 1% than 2% for much of 2016.

The economists said the strong housing market was clearly worrying the Reserve Bank.

“…Governor Wheeler reinstated housing as an issue of direct concern for monetary policy, mentioning the risk of low interest rates inflaming the housing market. That’s quite a turnaround – the RBNZ downplayed the housing market when it decided to cut the OCR in June, to our surprise at the time. And the September Monetary Policy Statement pointedly omitted any forecast of house prices.”

The economists said while Wheeler’s speech confirmed that the RBNZ still intends to reduce the OCR below the current level of 2.75%, other comments “were hawkish”.

“In addition to the housing market, the Governor referred to encouraging local economic data, and to the virtue of correcting deviations from the inflation target only slowly. And he eschewed reference to the renewed vigour of the exchange rate.”

As result of these comments, the Westpac economists said they remained “very comfortable” with their forecast that the RBNZ would make no change in the OCR at the October Review next week and they concluded that the RBNZ was still just planning one further OCR hike in the current cycle, most likely in December.

Looking at the housing market, the economists said some of the shift in regional focus is due to Aucklanders buying houses in cheaper centres nearby.

“…But Reserve Bank and Government policy is also playing a role. For most regions of the country, lower interest rates and the upcoming loosening of mortgage lending restrictions is a stimulatory cocktail for house prices. Meanwhile, mortgage lending restrictions are about to be tightened for Auckland. And new tax rules targeting property ‘flippers’ are more of a negative for Auckland than other markets, due to the preponderance of speculators in Auckland.”

ASB’s Turner said one reason the RBNZ is reluctant to rush further cuts is that it wants to keep its powder dry in case the global outlook deteriorates markedly over the coming year. 

“This is a fair call given the growing risks to the global outlook. During the Global Financial Crisis the RBNZ was very mindful that at some point OCR cuts could become ineffective. In theory the RBNZ can cut all the way to zero. In practice, given NZ’s risk premium vs the rest of the world, OCR cuts could at some point lose potency in influencing other market rates.  Indeed, the US Federal Reserve ran into similar problems and had to resort to risky and untested methods to make monetary policy work more effectively.”

Turner said the third-quarter inflation outcome, while weak, may not be enough of a red flag to convince the RBNZ that lower rates are needed now.  

“However, we are more dovish than the RBNZ and we are not convinced inflation will pick up meaningfully in the next two years. There are some troubling details in the inflation report and recent business confidence surveys.  Also the recent rally in the NZD also threatens to undermine the RBNZ’s assumption that tradable inflation (largely imported retail items) is about to lift sharply. The recent NZD bounce gives a new window of opportunity for importers to lock in some hedging for those that missed out – there are quite a few relieved importers out there at the moment.

“The NZD is tricky for the RBNZ. A more dovish outlook would help take some of the air out of the NZD.  However, as mentioned above, the RBNZ does not want to shift its stance yet, in case the global economy deteriorates.”