Key Points
- The risks are evenly balanced. The RB will keep the OCR unchanged for “some time to come”, but will react in either direction to economic developments.
- So “if a butterfly flapped its wings and the world changed, we have more work to do” Adrian Orr.
- The OCR track was tweaked, and the expect return to inflation target postponed.
- The statement took some of the wind beneath the Kiwi’s wings. The NZD is down about 45pts.
- Kiwi interest rates steepened, with the 2-year falling 4.25bps.
Summary
David Tua was right: O is for Orrsome. New RBNZ Governor Adrian Orr delivered a suitably neutral commentary, with even-weighted risks either side. Over the next year the RB is just as likely to cut as they are hike. It all depends on the data, as it always does.
The statement was clever in its simplicity. The message was crystal clear and gave New Zealanders some certainty on interest rates. The labour market has tightened and is running close to trend. But inflation is unlikely to return to target (2%) until December 2020.
Orr is clearly set on simplifying the language. The opening line in the last statement was simply, “The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent.” Today, Orr noted “The official cash rate (OCR) will remain at 1.75 percent for some time to come. The direction of our next move is equally balanced, up or down. Only time and events will tell.” The statement was much clearer, from the first line throughout.
The all-important OCR track was tweaked just a touch. The June quarter in 2019 was rounded down from 1.9% to 1.8%. The track thereafter was unchanged. So lift off was delayed, but the path was unchanged. It was just enough to give a much needed “dovish tilted” for financial markets, without dramatically changing the language. Job done.
The subtle shift towards a more dovish bias, suggests the likely take off for policy normalisation has shifted closer to 2020. Our best guess is the RB will be in a position to start taking their foot off the accelerator around the middle of next year. We had pencilled in a May MPS lift off date. The risk is clearly tilted towards a November MPS lift off date. The difference is significant enough. But the key message remains, don’t fear rapidly rising interest rates - not this year, or next.
The dual mandate is half baked
With regards to the dual mandate, the economy has generated “an unprecedented increase in employment”. And according to the RBNZ’s Box C, we’re running close enough to trend. Unfortunately they didn’t speak much about underemployment, but the message is good (enough). On the darker side of the mandate, the inflation outlook is too tepid. The bank has postponed its forecast return to the 1-3% target mid-point of 2% by one quarter to December 2020. It’s hard to lift interest rates when you don’t see a sustained lift in inflation for over 2 years.
The Bank devoted a whole analytical box (Box C) to explain in more detail its ‘maximum sustainable employment’ mandate, linking it to the economy’s output gap. But this part of the mandate is likely to remain somewhat opaque, given the difficulty in estimating maximum employment. What we took from the MPS, is that the RBNZ is happy that it’s currently meeting this mandate. In addition, the RBNZ will not focus on any single labour market measure when assessing its performance against the employment mandate. This was demonstrated by listing an array of measures it has looked at (see chart below).
Tweaks made to the inflation outlook
The RBNZ revised down its forecast of inflation, much of it in the neat-term, to reflect softer tradables (or imported inflation). The revision means that the RBNZ’s forecast sees inflation hitting the Bank’s 2% target mid-point one quarter later than was presented in February. In or view the revisions to the Bank’s CPI track was minor in the scheme of things, with inflation expected to rise after hitting a trough of 1.1% yoy in March 2018. In our view, we believe the Bank’s inflation outlook to be too tepid. We see inflation being only around 9-12 months from returning to the 2% midpoint.
On the inflation front, the main focus for the Bank remains benign underlying inflation. The question remains, how quickly will capacity pressures feed into underlying and non-tradables inflation. The Bank see’s non-tradables inflation remaining around the current rate of 2.3% yoy until mid-2019 (when the recent drop from the fees-free tertiary education policy drops out) before rising over 3% yoy in 2020.
We took from that MPS that the RB is comfortable with inflation expectations, as they remain well anchored to the 2% midpoint. The RBNZ has for the last year somewhat de-emphasised the impact of inflation expectations on actual inflation. Firms’ price setting behaviour looks to be driven by past weak inflation, rather than expectations of future price pressure. Nevertheless one of the risk scenarios presented by the bank is that firms revert to expectations of inflation to guide pricing decisions. Under this scenario the RBNZ indicated that it would begin hiking the OCR by the end of 2018, and deliver around 50bps of additional hikes over the projection period.
The evenly balanced risks were bank funding and inflation.
The upside risk was the familiar lift in global inflation. The risk we all expect, but have failed to find. The downside risk was also something old, but something new.
The RBNZ’s emphasized downside risk is something Kiwi banks are monitoring closely. Financial market conditions have tightened offshore. The spread between where banks can fund and cash rates, has widened. To date, the pass-through from US financial markets to Australian financial markets has been clear. Aussie bank funding costs are higher. There are a plethora of forces at work. But Kiwi financial markets have not reacted in a similar manor. It is still a risk. Although we believe it is a diminishing risk. One of the Achilles’ heels of Australian and New Zealand banking system is the partial reliance on foreign funding. Developments in foreign funding markets can significantly impact the cost of banking domestically. And it is generally the cheapest source of funding. Regulation has forced a reduction in the reliance of foreign funding. But we are not immune. The RBNZ’s Box D explains the risk. If funding costs blow wider, interest rates offered throughout the economy rise. The spread between the RBNZ’s cash rate and mortgage rates, for example, widen. If persistent, the current OCR setting becomes less accommodative. And if that occurs at a time when the economy still needs support, the RB will lower the cash rate to keep settings as there where prior to the blow out. That’s the RB’s downside risk. A risk we think will dissipate in the short term. But we will watch with interest.
Market Reaction
Financial markets moved in the right direction. The Kiwi dollar was trading around 0.6987 before the announcement. At time of writing, the little Kiwi flyer had descended to 0.6939. The RB will be satisfied with the 48pt move. Although Adrian “doesn’t have emotion about the currency”, he knows a weaker Kiwi helps the inflation trajectory. In interest rate markets, the sweet spot 2-year swap rate eased a little from 2.278% to 2.238%. The 4bps decline in the two year rate is important. Banks use the 2-year swap rate to hedge their 2-year fixed mortgage rates. You don’t want the 2-year spiking higher if you want monetary policy to remain accommodative. Again, job done.
We expect the Kiwi to remain of a turbulent glide path lower into 2019. We forecast the bird to hit 0.67 early in 2019. It’s not a big move, but it’s the right move. The risk to our view is a more helpful descent to 0.65 or lower.