Thursday, September 12, 2013

A balanced statement from the RBNZ

A balanced Monetary Policy Statement (MPS) from the Reserve Bank of New Zealand today, but it’s not one without risks.  The good news is the Bank well-aware of those risks.  The key question for today was how the Bank would incorporate the imminent arrival of speed limits on high loan to value ratio (LVR) loans into the outlook.  More precisely we were keen to see what impact the Bank was expecting those restrictions to have on their projections for the housing market, the broader economy and most importantly their interest rate projections.

The Bank expects the introduction of high LVR restrictions from October 1st to lower house price inflation price inflation by 1 to 4 percentage points with a more modest effect thereafter.  They also expect growth in household credit to be 1 to 3 percentage points lower over the next year.  The Bank used the mid-point of those ranges for their central projections.  I agree there will be some impact and in the direction the Bank anticipates, but the quantum of those impacts is the moot point and will only be proven in time.  Therein lays the key risk to the Bank’s projections.

Other developments since the June MPS the Bank had to factor into their statement today were stronger-than-expected net migration, the stronger terms of trade and the recent depreciation in the New Zealand dollar.  All of those factors contributed to a rise in the projected interest rate track.  However, the resultant lower house price inflation from the LVR restrictions is expected to dampen household consumption and reduces the projection for the 90-day interest rate by 30 bps.   The net effect is an interest rate track in this MPS that is 50 basis points higher than in the June MPS with an indicative first tightening around March next year.

In general the outlook for GDP growth in the Bank’s forecasts is much in line with our own.  Their GDP track is a tad higher than ours, but there’s not much in it.  They had clearly finalised their forecasts before the recent run of weaker June quarter data which they acknowledged today took their published +0.4% June quarter forecast down to +0.1%.  That compares with my zero.   But this largely reflects the lingering impact of the summer drought which has been followed by the good growing conditions that comes with a warm winter so a low June quarter number should be seen as little more than a “statistical burp”.  At the same time their September quarter forecast of +0.8% is probably a bit light.

The Bank stuck to the line of not expecting to raise rates this year. That’s the final nail in the coffin for my December tightening prediction.  That nail had already been driven two-thirds in with the continued commitment to keep rates unchanged at the time of the announcement of the LVR restrictions in August.  I’m now with the consensus (and of course the Bank) with a first hike in March next year.

Here’s the risk.  The Bank is expecting LVR restrictions to have a meaningful impact on the housing market, consumption and inflation.  My definition of “meaningful” is sufficiently meaningful to have an impact on the interest rate track.  The danger is LVR restrictions don’t have a meaningful impact, but in waiting for that impact to occur the Bank finds themselves behind rising inflation pressures.  The early warning signs of inflation are emerging in expectations surveys, pricing intentions and rising capacity utilisation.

Leaving it too late would then require a more aggressive tightening further down the track.  Remember the “give growth a chance” mantra from the 2003-07 cycle that saw the OCR eventually peak at 8.25% and a domestic recession.  My preference is still for an early and gradual approach to the cycle.  There’s only one hurdle for me getting what I want: I’m not the Governor of the Reserve Bank.

Taking an early and gradual approach seems to me to be the best chance of locking in a low interest rate cycle and minimising upside risk to the exchange rate over time.  I get the concern about higher interest rates impacting on the exchange rate, but there’s more to the exchange rate than interest rate differentials, not the least of which is the rampant terms of trade and quantitative easing in some countries.  And of course there will be more news on that front with the FOMC meeting next week.  Watch this space.