Key Points:
- The RBNZ left the OCR unchanged at 1.75% this morning as widely expected.
- However, the tone of the Statement was a surprise. The RBNZ maintained a neutral stance, suggesting that the risks to its outlook remain evenly balanced.
- The RBNZ’s OCR track assumptions were also unchanged, with gradual rate hikes starting from the second half of 2019 and an OCR of 2% by mid-2020. This is much more cautious relative to market pricing which prior to the MPS had 100bps of hikes priced in.
- The RBNZ appears wary about signalling OCR hikes until they are absolutely sure that inflation pressure is substantially building in the NZ economy.
- Despite the very cautious tone in this morning’s MPS, we maintain our view that OCR hikes will be required earlier than the RBNZ is currently projecting. We expect OCR hikes to kick off from the late 2018.
Summary
Today’s May Monetary Policy Statement (MPS) from the RBNZ contained a few surprises for us and market participants. While the RBNZ left the OCR unchanged at 1.75%, as widely anticipated, the tone of the statement was more dovish than expected. We had expected the RBNZ to shift toward a mild tightening bias and move forward the start of forecast OCR hikes by around six months. However, the RBNZ maintained a very neutral tone and kept its OCR forecasts unchanged - with no rate hike implied until the second half of 2019 (the same as forecast in February). While we expected the Bank to maintain a cautious approach, today’s Statement is overly reticent in our view. It appears that the Bank could partly be suffering from a case of once bitten, twice shy after its previous experience of lifting the OCR in 2014, as well as considering the experience of other central banks around the world who have tightened monetary policy post GFC, only to have to quickly reverse that policy tightening (and then provide additional easing in many cases). Given these previous experiences we can understand a note of caution, but given recent data, we just don’t see the RBNZ sitting on its hands for another two and a half years without needing to shift the cash rate.
Outside of a global shock, we see the risks as skewed slightly toward the upside compared with the RBNZ, and certainly enough to warrant a more explicit tightening bias than was presented in the May MPS. We maintain our view that the most likely timing for the next OCR hike will be toward the end of 2018. Obviously this still remains quite some time away, and a lot can change in 18 months.
Growth rising off a lower starting point, less capacity pressure
The weakness in GDP growth over the second half of 2016 lowered the starting point for the RBNZ’s growth forecasts. Some of this weakness was caused by temporary factors that are expected to reverse at the start of 2017, although annual average growth over the year to March 2017 will be weaker than previously forecast. Beyond there however, the Bank’s output forecasts are actually higher over 2018 and 2019 than they were in the February MPS. The lower starting point for growth does means that the NZ economy is now operating with a greater degree of spare capacity at this point in time, which implies lower domestic inflation pressure in the near-term. The Bank suggests that the economy is currently operating at around capacity, with a zero output gap (i.e. the economy is operating at around trend). The extent of capacity pressure in the economy is still expected to rise over the forecast horizon, although strength of the positive output gap will have a shorter peak – generating less non-tradables inflation (see below for details).
At the same time, net migration continues to hit new records highs, currently running at an annual pace of 72,000 (with over 61,000 of those people of working age). The RBNZ only forecasts working age net migration and they expect to see that decline to a pace of 56,700 by the end of this year and then 42,000 by the end of 2018. We see a risk that if global labour market conditions remain subdued, at the same time as we see migration policies continue to tighten offshore, then we are likely to see the number of migrant work visas continue to rise. While net migration remains strong, it has had less of an inflationary impact on the economy than in previous cycles. This was due to the large concentration of net migrant gains of those aged 20-35, who typically consume less than older age groups. If we see a shift away from this younger cohort (who typically spend less) to an older age group, then this could boost consumption by more than currently forecast. In today’s MPS however, the RBNZ lowered its forecasts for household consumption in response to softer house price inflation and rising mortgage rates.
Looking at the construction sector, which the RBNZ expects to be a key growth driver over the next three years, the outlook for residential investment has moderated slightly in the near-term based on tighter capacity constraints and bank lending standards. The RBNZ highlighted a downside scenario whereby residential investment growth is more muted than in its central forecasts due to further tightening in lending standards and capacity constraints. In this case that generates lower capacity pressures in the general economy, but also higher house price inflation. Overall the net effect of these two factors is expected to be lower inflation pressure and would necessitate an extra 50bps worth of OCR cuts in order to keep inflation at target.
Housing market softer but risks remain
The housing market outlook and related drivers played an important part in the May MPS, with the RBNZ significantly revising down its forecast for house price inflation in the near-term (see chart below). While the supply/demand imbalance in the housing market remains due to strong net migration and lagging building consents (particularly in Auckland), recent policy changes, rising mortgage rates and muted wage growth are expected to limit further upside in house price inflation. Assuming no major changes in government housing policies (e.g. a capital gains tax), we still see a risk of another spurt higher in house price inflation once the September 2017 election has passed.
It is worth noting that the RBNZ is currently undertaking a review of capital requirements for NZ registered banks. Given international tightening of capital requirements, we doubt we are going to see these loosen anytime soon and we anticipate that regulatory capital requirements will move higher after the review. While the review isn’t due to be completed until Q1 2018, changes in capital requirements could cause a further slowdown in bank lending, restricting credit growth further. Housing-related credit growth now appears to have peaked, with credit growth pulling back from a pace of 9.1% yoy at the end of 2016, down to 8.7% yoy currently.
RBNZ looking through recent inflation bounce
In the RBNZ’s eyes, the recent shift higher in inflation has been dominated by temporary increases in tradables inflation from food and fuel prices. Food prices spiked higher at the start of 2017 due to weather-related supply disruptions. Petrol prices have gradually recovered from lows seen over the first half of last year. But the Bank was at pains to point out that the recent bounce higher in inflation is likely to be temporary, even including a standalone analytical box in the MPS on the matter. The unwind of recent gains in food prices, as well as flat oil prices over 2017, mean that the RBNZ is forecasting annual tradable to fall to -0.8% yoy at the start of 2018. This drags the Bank’s headline inflation forecast down from current 2.2% yoy currently to only 1.1% yoy in Q1 2018. This decline looks overdone based on our forecasts – we expect to see headline inflation dip down to 1.7% yoy in March 2018.
In response to the Bank’s upward revision to spare capacity in the economy (i.e. lowering the output gap), the RBNZ has lowered its forecasts for non-tradable inflation in the near-term. It is this domestic inflation side of the story that the RBNZ is focussed on. In the Bank’s view, a more tempered domestic inflation outlook warrants policy to remain accommodative for some time. While we believe that the RBNZ can afford to sit on its hands for a while longer, we suspect it will ultimately have to begin tightening monetary policy earlier than forecast in today’s MPS.
Throughout 2016, inflation pressures looked to be concentrated within housing-related goods and services as a result of a construction boom. However, March quarter CPI inflation data suggested that core inflation pressures were becoming more widespread. Nine of the eleven CPI sub-groups experienced a rise in prices in the March quarter. In addition the trimmed-mean measure, which strips out extreme movements on prices, posted a 2.1% yoy rise at the start of 2017, up from 1.1% yoy a year earlier. These measures contrast with the RBNZ’s sectoral-factor measure of core inflation, which has held steady at 1.5% yoy for six consecutive quarters – indicating more modest core inflation that the RBNZ cited today. While headline inflation expectations jumped higher in the RBNZ’s recent survey of expectations, longer-term inflation expectations remain well anchored to the middle of the target midpoint. Shorter-dated inflation expectations (e.g. 1& 2-year ahead) have been increasingly responsive to changes in actual inflation and hence the RBNZ expects these to jump around over the year ahead as headline inflation moves. If longer-dated inflation expectations hold steady around current levels, then we don’t expect to see the RBNZ react to changes in shorter-dated expectations of inflation.
Risks to outlook less balanced than suggested
The RBNZ’s assessment of risks in the May MPS suggests that upside and downside risks are evenly balanced. In the near-term we can see some argument for this given the on-going uncertainty surrounding the global outlook and US fiscal policy. However the domestic risks in our view remain skewed to the upside over the medium term. The RBNZ has maintained a very neutral tone, stating that “more or less monetary stimulus may be required”.
In addition to a downside scenario mentioned earlier involving lower residential investment, the Bank also included an upside scenario focused on higher capacity pressures. In this case, the RBNZ highlighted the uncertainties involved in estimating potential GDP and the output gap. If capacity pressure is stronger than in its central view, then there would be some upside to the Bank’s inflation forecasts that would necessitate the OCR to be lifted to 2% by the end of this year, with an extra 25bps rate hike by mid-2020.
Market reaction
Heading into this morning’s MPS, financial markets had been getting excited about the RBNZ shifting forward its OCR track and upward revisions to the Bank’s inflation outlook. In reality, today’s Statement was quite a disappointment. In response, the NZD/USD declined over a cent to be trading around $0.6835. The NZ dollar also declined against other major trading partner currencies, taking the NZ TWI down to just below 75.
Interest rate markets also reacted to the relatively dovish Statement, with the 2-year swap rate declining 7bps to 2.27%. The 5-year swap rate has declined about 6bps to currently trading around 2.86%. The OIS market has moved significantly following the MPS, with a rate hike now not fully priced until June 2018 (previously March 2018). However, OIS market pricing still runs well ahead of the RBNZ’s own forecasts with the OCR expected to reach 2.50% by March 2019.
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