Tuesday, April 26, 2016

Four things the RBNZ will be thinking about in deciding whether to cut this week

When the Reserve Bank of New Zealand (RBNZ) surprised the market with its decisions to cut interest rates in March, it flagged another rate cut was on the way. Usually we would say “just do it”, but the decision whether to cut again this week appears more finely balanced. So what are the things the Bank will be thinking about in the lead-up to Thursday…?

Inflation: The March quarter CPI was bang-on RBNZ expectations, though the mix of tradeable versus non-tradeable inflation showed greater than expected pressure in the latter. In fact non-tradeable inflation has now risen 1.5% over the last six-months. Non-tradeable inflation (ie domestic inflation pressure) is more important for setting monetary policy. But at an annual rate of 1.6%, non-tradeable inflation was still lower than the 1.8% recorded in the year to December.

The exchange rate: At the time of March rate cut the Trade Weighted Exchange Rate Index (TWI) was around 72.5 and the RBNZ assumed an average of 70.9 for the June quarter.  So far it has averaged around 72.7.  All else being equal (and assuming the TWI stays at current levels for the remainder of the quarter) that would shave around 0.3% off inflation in 12-months time.   Part of the strength in the NZD/USD has been the recent weakness in the USD as the US Federal Reserve has recalibrated from four interest rate increases this year to two.  We think the Fed will raise rates again in June which will see some recovery in the USD and downside for the NZD, but we think we have seen already the highs in the USD for this cycle.

Housing: We weren’t expecting the RBNZ to cut interest rates in March. Our view was that given much of the reason for current low inflation was (arguably) outside the control of the RBNZ, the higher-inflation reward from lower interest rates wasn’t worth the risk to financial stability of inflaming the housing market. Indeed, household debt continues to rise, fuelled in part by record low interest rates. As it turned out, the Bank was reasonably sanguine about the housing market in March, no doubt reflecting a softening in both price and activity data following the introduction of measures to cool the housing market last year. The question is the extent to which they have been surprised by the recent renewed strength in the market, or are relaxed given their ability to deploy other (macro-prudential) tools from their tool-box.

Growth: GDP growth was stronger than the RBNZ was expecting at the end of last year, but there was probably nothing in that result itself that will alter the Bank’s forecasts for the period ahead. Some of the more recent partial data has been a bit stronger than we were expecting (migration, tourism flows, dairy prices), but then our 2016 GDP forecasts are lower than the Bank’s so these results might have been less of a surprise to them!! Add to this, the downside risks to global growth have diminished further since March, notably in China.

All things considered, it’s a close call as to whether the Bank cuts this week. But it’s the recent strength in the exchange rate along with consistency of approach that gets us just over the line in expecting them to cut the OCR to a new record low of 2.0% on Thursday. Furthermore, if they don’t cut this week, it will likely prove to be for reasons that mean there is a reasonable chance we may have seen the low in interest rates for this cycle.