RBNZ Observer Update: Quake drives 50bps cut

10 March 2011 For immediate release

RBNZ Observer Update: Quake drives 50bps cut

The RBNZ cut the OCR by 50bps to 2.5%, a larger cut than market pricing implied (33bps). Economists were split, with 5 for hold (including HSBC), 4 for a 25bps cut and 6 for a 50bps cut. The RBNZ suggested confidence was substantially hit by the February 22 earthquake and that conditions were already weak in the lead up. Cutting interest rates after a negative supply shock is an unusual move, and potentially risks uncomfortably high future inflation. Focus will now turn to when this will be reversed, given the OCR is now at emergency levels while commodity prices are rising strongly and global inflation is picking up.

Facts

- The RBNZ cut the cash rate by 50bps to 2.5%, more than market pricing suggested (33bps).

- Governor Bollard indicated that economic activity will be negatively impacted in Christchurch, but also nationwide. He also suggested that 'even before the earthquake, GDP growth was much weaker than expected through the second half of 2010' and that signs of recovery in 'early 2011 have been more than offset by the Christchurch earthquake'.

- The RBNZ has indicated that they expect that 'the current monetary policy accommodation will need to be removed once the rebuilding phase materialises' and that this 'will take some time'.

- Forecasts for inflation were largely unchanged, with CPI expected to be 2.1% in 2012 (unchanged from the December official statement).

- GDP forecasts have been revised down to 0.9% in 2011 (from 1.7%) and 2.7% in 2012 (from 3.4%). RBNZ Observer Update: Quake drives 50bps cut/2

Implications

Cutting interest rates in response to a negative supply shock is not the textbook response. While an event like this weakens the economy in the short run, it adds to medium-term growth as the capital stock is rebuilt. In this case there will be substantial addition to GDP as rebuilding occurs in the Canterbury region, with the RBNZ estimating capital stock damage of 8% of the value of nominal GDP. While the rate cut may boost confidence in the short run, the risk is that rebuilding and broader economic recovery - partly due to strong increases in commodity prices -sees inflation hold persistently above the RBNZ's target zone. A targeted fiscal package would seem to have been a more appropriate response (see The RBNZ Observer, 8 March 2011).

The RBNZ has judged that the rebuild will take considerable time and the reduction in demand in the interim - via weakened confidence and disruption - is sufficient that demand will not run ahead of supply and put upward pressure on inflation over the forecast horizon. The RBNZ's inflation outlook is largely unchanged from that presented in the last official statement. In our view there are a number of considerable upside risks to inflation. These include that global inflation is building, oil prices have risen, other commodity prices have risen, and a large automatic fiscal response to the quake, via the Earthquake Commission, will boost the economy over coming quarters.

The OCR is now back at emergency low levels of 2.5%. The focus of discussion will now turn to how soon before the RBNZ will need to begin to reverse this decision and lift rates. This uncertainty may indeed have the effect of dampening confidence.

Bottom line

The RBNZ cut the OCR by 50bps back to emergency levels (2.5%) in response to the February earthquake. This was a larger response than markets expected. At such a low level the risk is that inflation holds above the RBNZ's target zone for longer than is comfortable.

Paul Bloxham, Chief Economist (Australia and New Zealand)

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