Thursday, March 14, 2013

RBNZ more dovish...or is it?

After a December Monetary Policy Statement (MPS) that was widely perceived to be more hawkish than expected, the March MPS is being interpreted as dovish.  However, I wonder if it is quite as dovish as it looks.

The MPS noted the positives of the receding risks around the global outlook, financial sentiment has improved, the Canterbury rebuild is gaining momentum and residential investment, business and consumer confidence are increasing.  On the downside, the labour market is weak, the overvalued dollar is undermining profitability in export and import competing industries, the drought is creating difficulties and ongoing fiscal consolidation will also act to slow overall demand.  Yep – we agree with all of that. 

The question is what that means for monetary policy?  The fact the Reserve Bank believes there are upside and downside risks to the outlook means it’s a balanced outlook.  I try to do the same thing.  Even with a balanced assessment, the interest rate projections indicate the Bank believes the next move in interest rates is up.

The key factor causing the Bank consternation is the high level of the exchange rate.  The Trade Weighted Exchange Rate Index (TWI) has appreciation by around 4% beyond the level assumed in the December MPS, largely due to the recent weakening in the Japanese Yen and the British Pound.  As a result, the Bank’s inflation forecasts are lower than the previous forecasts, despite a growth outlook that is largely unchanged.

I believe the Bank is right to retain a tightening bias.  I agree with them when they say:

 “An elevated dollar will continue to dampen tradeable inflation.  As a result, annual inflation is expected to remain around the lower part of the band over the coming year.  Further ahead, resource pressures are expected to accumulate, in response to a rise in investment spending, strength in the housing market and low interest rates.  As a result, domestic inflationary pressures will begin to build.”

The Bank must keep a medium term focus and not become too pre-occupied with near-term factors.  Again from today’s MPS:

“During previous periods when inflation temporarily rose above the target band, the Bank did not attempt to rapidly reduce pricing pressures.  Analogously, we are mindful that, because of policy lags, efforts to offset the current weakness in inflation may have an only limited impact on near-term conditions.  Furthermore, such efforts could exacerbate medium-term inflationary pressures.” 

For those very reasons I believe the chances of an interest rate cut remain low.  A cut now would simply exacerbate inflation problems further down the track, leading to the risk of even higher interest and exchange rates. 

While it appears macro-prudential tools are firmly on the agenda, we continue to believe such tools are more about financial stability than price stability.  Essentially that means the introduction of such tools will have limited impact on the appropriate level of interest rates: our interest rate forecasts remain the same regardless of whether we see such tool employed or not.

I still see a first hike in the OCR in December this year with a peak at around 4.5% which continues to be our estimate of the “new normal” neutral rate.  Fiscal drag should be sufficient to offset any need for rates to remove beyond neutral.  However, that continues to assume the Bank is sufficiently pre-emptive in removing the current high level of monetary accommodation.  The risks are just about when they start to tighten.