Thursday, March 10, 2011

RBNZ takes out insurance

It's hard to take issue with the RBNZ's decision to cut the Official Cash Rate by 50bps today when given its portrayal as an insurance policy against an economy recovery that was already weaker than anticipated, even before the February 22nd Christchurch earthquake. Setting aside the merits, or otherwise, of today's move, the key question now is: Where to from here?

We have been staunch advocates of the "This time it's different" view of the economic recovery. This has had, at least for us, obvious implications for monetary policy. The series of seismic events that have hit Canterbury have complicated the outlook.

Our starting point has always been the only contribution monetary policy can make to a sustained economic recovery is to keep inflation expectations well anchored. That is no less true today than it has been at any time in the past, or is indeed likely to be in the future.

Given our belief that the recession and subsequent recovery have been largely structural in nature, potential growth is now lower than it has been previously. That means capacity constraints would get hit earlier in the cycle this time. Furthermore, given the significant (and appropriate) easing in monetary policy that occurred during the GFC, monetary settings have been exceptionally stimulatory.

For those reasons, we long favoured an early and gradual removal of the very accomodative monetary conditions that have been in place. We were, you may recall, in favour of the tightenings delivered by the RBNZ last year (leading some of you to comment that we were overly hawkish). Our support was driven by the fact that with a preemptive and gradual tightening, a lower overall interest rate cycle was possible, unlike the previous cycle where the RBNZ was constantly behind the inflation problem.

So here we are back with an OCR at 2.5% and an economy in a very different place. But the point remains that the best contribution monetary policy can make to a sustained recovery is to keep inflation expectations in check.

We are, today, further away from wherever the new normal neutral OCR is (another complicated and uncertain question!!). So we now remove the "gradual" part of our preferred "early and gradual" approach to exiting the exceptionally accomodative monetary policy settings. It now seems likely that when the time is right, later this year or very early next year, monetary tightenings will be far more aggressive. A move to an OCR of around 4.5% still seems an obvious place to head, at least in the first instance.

I like the fact the RBNZ Governor went to have a chat with the Minister of Finance before determining his course of action. You will recall that one of our Themes for 2011 was (and still is) the relationship between fiscal and monetary policy as accomodative policy settings were removed. If conversations between the Governor and the Minister lead to a greater degree of co-ordination between monetary and fiscal policy, that's gotta be a good thing.