RBNZ easing in March remains doubtful

Data Flash (New Zealand) NZ:
RBNZ easing in March remains doubtful

The markets are pricing a 25 bp rate cut on 14 March .

New Zealand debt markets have priced in a 25 bps easing by the RBNZ on 14 March, followed by another 25 bps in May. Such a profile would reflect the international environment: the Fed has eased 100 bps over the past month and is expected to go by another 50 bps in March, the Bank of Canada eased by 25 bps last week and the RBA is expected to follow on 7 February. Current market pricing implies the underlying view that it will be difficult for the RBNZ to ignore these global trends. We believe, however, that there is a more than 50% chance that the RBNZ will indeed withstand the pressure to ease - at least in the near term. . despite non-committal Brash comments

As set out below, considering the RBNZ's policy reaction function and the fact that the NZ economy appears to be at a different cyclical stage than other economies, the case for an easing in March is far from proven. In fact, Don Brash did not say anything after the OCR review of 24 January that suggested he was biased towards an easing in the near future. While Brash mentioned the slowdown in global growth, the stronger-than-expected rebound of the NZD, and the short-lived inflation spike, this was done in the context of justifying why he was moving away from the tightening bias expressed in the December Monetary Policy Statement (MPS). In the absence of those factors the RBNZ would almost certainly have hiked rates at the review, as demonstrated by Brash's concluding comment that `Given these factors, we feel we can prudently leave the OCR unchanged for the moment'. There was no hint of an easing bias for March. Nor did Brash signal anything in the comments he made after his Christchurch speech on 26 January. He reiterated the high level of domestic confidence indicators and noted that the exchange rate was still stimulatory. Both factors would count against an easing bias.

What makes the RBNZ tick?

To shed some light on the issue of a March easing, it is important to remember the RBNZ's reaction function. The RBNZ will not ease simply because other central banks have taken the lead. The Bank needs to be convinced that the easing steps by other central banks or the reasons for those moves are going to impact on the medium-term outlook for domestic inflation. The December MPS was a timely reminder that the Bank continues to be firmly focused on achieving medium-term inflation around the mid-point of the 0-3% target range. The key criterion for a policy easing is a projection that inflation is threatening to fall below 1.5% on a sustained basis. Is such projection likely at this point?

Inflation has peaked, but a 1.5% underlying rate is a long way off CPI inflation reached 4.0% over the past year. While this was driven to a significant extent by petrol prices and tobacco tax increases, inflation excluding those influences was still around 2.5%. The weak NZD has been a key influence behind the rise in tradeables inflation and the partial recovery of the NZD should dampen the gradual pass-through of higher import costs into consumer prices over the next year. The latest QSBO business survey still showed a high level of intended price increases, suggesting that, so far, businesses have passed only part of increased costs through. Some major retailers have already warned of further price increases and others are expected to use the NZD recovery to re-establish profit margins. Demand conditions appear to support such price-setting strategies, with the RBNZ having been surprised by the upward momentum in business and consumer confidence late last year. Furthermore, capacity utilisation has remained at or above its historical average despite the mixed growth performance in 2000. Wage inflation is another risk factor, given that the unemployment rate is at a 12-year low and skill shortages are worsening. Union leaders have become a little more vocal after recent high inflation data and union members are unlikely to be impressed with calls for wage restraint once beneficiaries (excluding superannuitants) are receiving inflation-indexed increases of 4% on 1 April.

Consensus view remains for renewed pick-up in global growth later this year While inflation pressure is expected to subside over the next 12 months, the above factors suggest that it may not be a smooth ride. The question is whether global forces will convince the RBNZ as early as March to depart from a prudent wait-and-see approach. That will obviously depend on the shape of the global slowdown. Most commentators, including Deutsche Bank, are looking for relatively short-lived weakness. Q1/2001 is seen as the bottom of the US cycle, with pro-active Fed action and confidence effects associated with the prospect of massive tax cuts providing the key ingredients for a return to 2-3% growth during the second half of this year. Pricing in fixed interest markets, as well as US equity market and commodity price trends, seem to be based on similar expectations. Global growth for the 2001 year as a whole is likely to be down to 2.5-3.0%, from the exceptional 4.5-5.0% experienced last year. World growth of 3.5% is forecast for 2002.

Low NZD will support export outlook

The RBNZ will factor a weaker export outlook into their forecasts. We expect a downward revision to export growth over the next year from 7.5% to around 4-5%. Such an outlook compares favourably with the period following the Asian crisis when export growth slowed to around 2%. The 1997/98 period is frequently being quoted as an example of the severe consequences the global slowdown could have for New Zealand. It should be remembered though that in 1997/98 the average NZD value was around 15% above where it is now and New Zealand commodity producers experienced their second drought in a row. Furthermore commodity prices were coming off in line with weaker global demand. The current downside risk to commodity markets appears significantly more limited, given that prices never reached the highs that would have been consistent with near 5% world growth last year.

Another potential transmission channel from global influences to domestic inflation is the considerable interest rate gap that opens up if other central banks ease and the RBNZ stays put. It can be argued that that provides support for the NZD, causes an implicit tightening in NZ monetary conditions and allows the RBNZ to ease. However, this influence has already been factored into market pricing (futures and currency markets) and RBNZ decision-making (Brash referred to the strength of the NZD as one reason why the pressure to tighten has abated) and is not going to emerge as a new factor driving policy decisions.

Conclusion

Domestic confidence indicators have strengthened recently, capacity utilisation and the labour market are relatively tight, core inflation is significantly above the RBNZ's implicit 1.5% target level, and the NZD remains very stimulatory. Those factors suggest that the RBNZ will retain its wait-and-see approach and resist calls for an easing in March. While the global growth slowdown will lead to a downward revision in the RBNZ's GDP forecasts, the Bank is expected to assume - consistent with international Consensus forecasts - that world growth will start to recover relatively soon. Such a profile would be consistent with keeping NZ cash rates on hold for most of 2001. The RBNZ will definitely want to avoid a situation where it decides to ease, only to be convinced soon afterwards that such a move was premature. We believe that the RBNZ will require more domestic confidence, activity and inflation data and more evidence about international trends before it would seriously contemplate an easing. It is unlikely that there will be enough conclusive data available prior to 14 March.

Ulf Schoefisch, Chief Economist, New Zealand

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