Friday, May 15, 2015

RBNZ: To cut or not to cut and what to keep a close eye on

Interest rate markets have priced in the increasing likelihood of cuts in the official cash rate (OCR) this year.   That follows continued low inflation outcomes and the shift to an easing bias by the RBNZ at its April OCR review.  Further impetus was provided by a generally weaker than expected March quarter labour market report and this weeks tweaking of LVR restrictions.  While the odds on a rate cut this year have risen, I’m still not convinced we will see lower interest rates this year and even less convinced that rate cuts are imminent.

I’ve written many times about the reasons behind New Zealand’s recent low inflation experience.  In short, low global inflation, the sharp drop in oil prices and an unsustainably high exchange rate has contributed to deflation in traded goods.  At the same time non-tradeable sector inflation has been kept well under control despite strong growth in the economy by strong growth in the economy’s capacity to grow without generating inflation.  That is best exemplified by recent growth in employment that has coincided with increased supply of labour via net migration inflows and an increasing participation rate.  This has resulted in continued benign wage inflation.


In its April OCR statement the RBNZ was pretty clear about the things that matter in determining whether rate cuts are on the way:  “It would be appropriate to lower the OCR if demand weakens, and wage and price-setting outcomes settle at levels lower than is consistent with the inflation target.”

Growth looks set to retain a solid 3% pace for a while yet, primarily supported by construction activity and consumer spending. Yesterday’s strong retail sales report supported the consumer spending story but also highlighted the inflation challenge with prices falling.  The biggest risk to the growth outlook is dairy prices.  My assumption has been dairy farmers will cope with one year of soft prices, but a second year would present more of a challenge. 

I expect growth will be begin to slow from later next year as we pass the peak in the Canterbury rebuild and as population growth slows.  But population growth slowing means that as GDP growth slows, potential growth will be slowing too.

Wage growth is certainly lower than I expected it would be at this stage of the cycle.  Even so, the private sector ordinary time Labour Cost Index (LCI) is at 1.8%.  Remember the LCI is effectively a measure of unit labour costs.  That says to me that wage inflation isn’t far off being consistent with CPI inflation of 2% over the medium term.  I’m expecting the LCI to continue to head modestly higher this year and into next year.

And then there’s the exchange rate.  The RBNZ’s shift to an easing bias and the expectation in the market of lower interest rates has had a significant impact on the Trade Weighted Exchange Rate Index (TWI).  The TWI has fallen around 4.5% since mid-April, helped most of all by a near 7% decline in the NZD/AUD as monetary policy expectations have shifted on both sides of the Tasman.  That follows an earlier adjustment against the USD as markets started to anticipate higher US interest rates.  The lower TWI is a positive development although I acknowledge at least part of this is predicated on the expectation of lower interest rate.

So where does this leave things?  I’m not yet ready to accept the economy needs further stimulus.  It is not yet clear that we can get through the cyclical peak in growth and capacity utilisation without that putting upward pressure on inflation.  I’m certainly not expecting the RBNZ to cut rates in June:  I don’t see why they would risk firing a rocket under the Auckland property market, at least before their LVR tweaks are in place.  So I still think interest rates are on hold for the foreseeable future, but the outlook is quite uncertain.  Things to keep a close eye on are dairy prices, the TWI and wages.