Thursday, September 15, 2011

New Zealand Monetary Policy

As expected the Reserve Bank left the Official Cash Rate (OCR) unchanged at 2.5% at todays Monetary Policy Statement. The press release was quite different from the one released at the time of the July OCR Review which signalled the imminent removal of the 0.5% earthquake “insurance” cut. Indeed that insurance policy has now been swapped for one against another potential disaster: a sharp slowdown in the global economy.

Reading the Statement highlights the challenge for the Bank in setting monetary policy right now. On the one hand the domestic economy is performing well. GDP growth appears to be gathering momentum, the terms of trade is at a multi-decade high and is likely to remain elevated, and spare capacity is being absorbed. Skill shortages are emerging in the labour market and inflation expectations have risen recently (although the Bank expects that to moderate). All of those are inconsistent with an OCR at 2.5%.

However, like us, the Bank is worried about the world. All of the positive domestic economic indicators count for nothing if the world takes a serious turn for the worse. For that reason the Bank left the OCR unchanged today and isn’t flagging an increase until early next year. Furthermore, higher bank funding costs and a higher projected exchange rate has the Bank projecting a lower interest rate track with 90-day Bills now peaking at 4.3% in 2013/14, rather than the 4.9% forecast in the June MPS.

On the back of today’s Statement we are shifting our expected first interest rate hike from December 2011 out to March 2012, but still expect that first increase to be 0.5%. Once the time is right, the Bank will have to get on with the job. Of course it is possible that global economic conditions improve before then in which case the Bank could well tighten earlier than this. We are keeping to our expected OCR peak of 4.5%, even though the Bank’s interest rate forecasts imply a peak of 4%.