Thursday, March 8, 2012

New Zealand Monetary Policy

Unsurprisingly, the Reserve Bank of New Zealand (RBNZ) left the Official Cash Rate (OCR) on hold at 2.5% this morning. However, they pushed out the expected timing of the first hike to the end of this year and reduced the extent of projected interest rate increases.

That’s all fine by us. Our somewhat imprecise expectation (we’ve given up being precise about the start of interest rates hikes, having shifted our timing half-a-dozen times over the last 18-months or so) has, most recently, been for the increase in the OCR to begin towards the end of this year.

What hasn’t changed is our view on the extent of interest rate increases we expect to see over the next cycle. Assuming a start to the tightening cycle late this year, we expect the OCR to be at around 4.5% by late 2013.

That’s more aggressive than the RBNZ is currently projecting. The Bank has lowered its forecast track in each of the last two Monetary Policy Statements: in December in response to higher bank funding costs and in this latest MPS because of the rise in the New Zealand dollar since the last Statement and the lower than expected December quarter CPI out-turn. But when the time comes, we don’t think the RBNZ’s projected track will be sufficient.

While our forecast interest rate track is more aggressive than the RBNZ’s, it is still for a relatively modest interest rate cycle this time, at least by New Zealand standards. A move up to 4.5% takes the OCR back to its previous low, and a peak at that level would be well below the 8.25% peak immediately before the GFC.

The lower cycle going forward is not just about the lower expected growth profile ahead. That’s because potential growth is also lower. That, in turn, means capacity constraints are likely to emerge earlier in the growth cycle. In economist-speak, the “output gap” might not be as big as some measures currently have it. That’s especially the case in the labour market where we believe capacity constraints (skill shortages) will emerge first. Watch this space.

The more important factor is that fiscal policy is expected to be contractionary over the next few years. That will reduce the amount of work monetary policy needs to do when the time comes to start removing some of the stimulus. That’s not just a New Zealand story – that phenomenon is likely for most of the developed world.

Of course there remains a higher-than-usual degree of uncertainty around the economic and monetary policy outlook. We have considerable sympathy for the RBNZ as it carefully constructs the messages in each MPS, especially the highly sensitive forward interest rate track. Transparency is a great thing, but it can’t be easy in times of heightened uncertainty. We think the Bank’s doing a pretty good job.