Next week's MPS may be last in Reserve Bank easing cycle
The Reserve Bank is expected to cut the official cash rate to a record low 1.75% next week in what's seen as the final act in an easing cycle that's proved ineffectual in the face of extraordinarily weak global inflation.
The odds of governor Graeme Wheeler cutting the OCR a quarter-point to a record low on November 10 is about 60%, based on the overnight interest swap curve.
Investors will be looking at the projections in next week's monetary policy statement for confirmation the easing cycle is at an end. The August MPS correctly forecast annual inflation of just 0.2% in the third quarter and sees a pickup in the fourth quarter to an annual 1%, which would be the first time in about two years that inflation has been within the 1-3% band the central bank targets.
Mr Wheeler said on September 22 that "policy stimulus to date, the strength of the domestic economy, reduced drag from tradables inflation, and rising non-tradables inflation" would all conspire to drive up inflation. Unfortunately, the outcome of next week's anticipated rate cut is more uncertain than usual, since it will come hard on the heels of the US presidential election and could well be overshadowed in financial markets. Since the last MPS, the kiwi dollar has gained on a trade-weighted basis, to reach a two-month high of 78.60 today, or 3.6% above the average level the bank projected for the fourth quarter.
"Failing to deliver what's been signalled would risk a sharp move higher in the New Zealand dollar and wholesale interest rates, which would flow through into retail lending rates – effectively an unwanted tightening of monetary conditions," said Michael Gordon, acting chief economist at Westpac Banking Corp. "Beyond next week's decision, the Reserve Bank is likely to retain a mild bias toward further easing. But we expect the OCR to remain on hold through 2017."
Mr Wheeler has a difficult message to get across.The domestic economy has proven stronger than the central bank had anticipated with a rebound in dairy commodity prices and a labour market where the participation rate has climbed above 70% to a record, albeit, partly explained by changes to the way the data is calculated.
The challenge for the Reserve Bank is that if it gives too strong an impression that interest rates have bottomed, longer-term rates could rise sharply as traders scramble to predict when OCR hikes will begin," Mr Gordon said. "Consequently, we expect that the Reserve Bank will retain at least a mild bias toward further OCR cuts."
New Zealand inflation expectations for the next two years have increased, according to the Reserve Bank's latest quarterly survey, released this week. Inflation one year out is seen at 1.29%, up from 1.26% in the previous survey, while the two-year ahead figure edged up to 1.68% from 1.65%. Meanwhile, the jobless rate fell below 5% for the first time since December 2008 as the labour market picks up pace while generating little additional wage inflation.
"Beyond November, we expect the Reserve Bank to remain on hold," said Nick Tuffley, chief economist at ASB Bank. "The risks do indeed remain skewed to further action but strong economic momentum and rising dairy prices will generate greater inflation pressure over time."
Those risks include further strength in the kiwi dollar, which keeps a lid on imported inflation, softening in inflation expectations and further global weakness and uncertainty, he said.
Interest rates have already been rising, although the gains have more to do with a global selloff in bonds than changing perceptions for New Zealand. The 10-year swap rate, at about 2.89%, near its highest in four months. But competition in the home-loan market means mortgage rates have barely budged, with an average two-year fixed loan about 4.49%, up from 4.35% in June, according to interest.co.nz.
Next week's MPS will market the first where the Reserve Bank gives a projection for the OCR rather than the 90-day bank bill, which hasn't been closely enough correlated with the benchmark rate to make it an accurate signaller for the central bank.