Economists' comments on Reserve Bank cash rate cut - and what's next

UPDATED: As widely expected, the Reserve Bank cut the official cash rate to 2.5% from 3% in response to the devastating earthquake in Christchurch in February.

Below are economists' reactions and comments on the bank's Monetary Policy Statement:

TD Securities – Annette Beacher and Roland Randall: 
Bottom line: The bank’s current thinking is that interest rates will rise by 50bps over the second half of 2011 and then remain on hold over 2012. How this is going to shore up business and consumer confidence is questionable.

• The MPS includes projected bank bill rates (although unlike tradition this was limited to a year-end profile rather than quarterly one), which suggests the rate cut will be completely reversed by the end of this year, then the OCR will be on hold at 3% over 2012 before climbing another 100bps to 4% over 2013.
• In the Q&A, Dr Bollard said the bank did consider an emergency cut but thought it could be “dangerous” acting on very little information, so decided that there was limited downside in waiting for the regular decision date.
• The MPS was otherwise brief relative to normal, lacking the usual write-up of the macro economic outlook. 
• The bank believes it is adhering to the Policy Target Agreement it has with the government by forecasting inflation to remain within the 1-3% target band. The weaker start to the economy than previously expected meant the bank expects inflation to remain under control. But questions by economists in the lockup did query the benign inflation outlook given global pressures on food, fuel, etc, as well as the boost during the reconstruction phase next year. The Reserve Bank's view is that the earthquake is currently a local event but data will be affected nationally.
• Reserve Bank chief economist John McDermott emphasised this cut was insurance and temporary, and the softer economy meant could deliver -50bps. But he  was very clear that forthcoming weak data was not going to mean another cut, but in fact stronger data means that cut will be reversed.
• The fact that Reserve Bank easing was openly discussed by Prime Minister John Key ahead of the decision somewhat compromises the independence of the Reserve Bank.
• Market implications: The NZD gapped lower on the decision, but then recovered to around $US0.7390. Traded lower through Dr Bollard’s Q&A to $0.7370. Swaps also gapped lower, but settled just 5bps lower in two-year swaps, 2bps lower in five-year swaps and 1bp in 10-year swaps. Similar moves were seen in bonds. The overseas market is now pricing +25bps by January 2012, probably a little more hawkish than the path suggested by the Reserve Bank’s bank bill projection.

Citi - Reddy Akash: 
Bottom line: Citi expects the Reserve Bank to keep the official cash rate at 2.50% until the second quarter of 2012, when we expect a 50 bps increase. 

• The cut was a form of insurance with the Reserve Bank stating that “it is appropriate for monetary policy to become more supportive to offset the resultant negative impact of the earthquake on economic activity and inflation.”
• Even without the earthquake, economic activity was weaker than expected. The accompanying official cash rate statement noted that “GDP growth was much weaker than expected through the second half of 2010”. Furthermore, evidence of recovery so far in 2011 in measures of confidence and spending has been more than outweighed by the impact of the Christchurch earthquake. GDP growth could now contract in the first quarter of 2011.
• More than the usual amount of uncertainty going forward that will test the economic assumptions. As a result, the Reserve Bank has reduced the scope of the economic projections in the quarterly Monetary Policy Statement (MPS). That said, economic growth is projected to fall 0.1% for the year to March 2011 but rise 5.4% for the year to March 2012. CPI-based inflation is likely to be boosted by price rises for dwelling rent and insurance in the short term. A more persistent influence on inflation is likely to be the boost to prices from the rebuilding effort to the Canterbury region that closes the current output gap.
• If activity worsens over the next few months, do not expect a further official cash rate cut. The Reserve Bank emphasised that the Reserve Bank's temporary measure will need to be removed as economic activity improves. 
• The Canterbury reconstruction effort is assumed to begin in 2012 and last for up to a decade. In addition, the Rugby World Cup is expected to add about $700 million to the economy from September 2011 (one-third of a percentage point of GDP) and rural commodity prices continue to rise. Also, the employment outlook is better than in the December MPS, falling to under 5% by the end of 2012 from 5.5% previously.
• The Reserve Bank effectively expects the official cash rate to rise 100 bps in 2012. The 90-day bank bill is expected to rise to 4.2% from 2012 to 2013. The shape of the yield curve and term structure of floating mortgages will enhance monetary policy’s ability to influence activity once recovery is under way. 
• Citi expects the Reserve Bank to keep the OCR at 2.50% until the second quarter of 2012, when we expect a 50 bps increase. The market currently has 14 bps of hikes priced in by the end of 2011. This will need to be increased as the year progresses.

JP Morgan – Helen Kevans
Bottom line: We expect the Reserve Bank to leave the official cash rate at 2.5% until 2012. We believe the OCR is the wrong tool to use in response to the earthquake.

• We believe the official cash rate is the wrong tool to use in response to the earthquake but acknowledge the decision was finely balanced and if a rate cut was to be delivered, it would have to be a 50bp move for policy to gain any traction. 
• Our view is that the Reserve Bank will stay on the sidelines for an extended period while officials assess the impact of the earthquake on the economy. The statement made clear today that future policy adjustments would “be guided by emerging economic data” but that the policy accommodation in place would not be removed until the rebuilding phase materialised. This will take some time.
• The earthquake caused substantial damage to property and buildings, and immense disruption to business activity. The Reserve Bank estimates the cost of the earthquake at around $15 billion (or 8% of GDP), but has signalled the reconstruction phase, which it says will be “very large,” will not begin until 2012. Thus, we believe that accommodative policy settings will be left in place until 2012.
• In 2012, the bank now forecasts growth will be 2.7% (compared with 3.4% previously), but will reach a well-above trend 4.7% in 2013 (up from 2.8% previously). In addition to the rebuilding effort, which will be significantly “growth-positive,” higher commodity prices, stronger exports, and the boost to tourism and sentiment from this year’s Rugby World Cup also loom as supportive of growth later this year and in 2012.
• The significant slack in the economy means, though, that the Reserve Bank expects inflation to remain contained, forecasting CPI growth over the forecast horizon beyond 2011 to hold comfortably within the Reserve Bank’s 1-3% target range. The Reserve Bank acknowledges there probably will be a boost to inflation pressure as a result of the earthquake. The concern for the bank would be the possibility that these price rises could lead to second round effects. Should higher prices start to flow through into higher inflation expectations, the Reserve Bank will be forced to remove the current stimulus sooner than we now predict. Indeed, with the exchange rate falling and global inflation pressures rising, New Zealand could see higher domestic inflation. Now, though, with underlying inflation weak, price expectations low, and firms lacking pricing power, there is little imperative to lift the OCR back toward neutral.

HSBC – Paul Bloxham
Bottom line: The 50bp cut was larger 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. 

• 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. 
• 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. 
• 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. 

National Bank - economics team
Bottom line: tightening cycle expected to begin from December 2011

• The Reserve Bank’s announcement indicated they expect to begin raising the OCR from current levels once the rebuilding phase begins in earnest. At this stage, our economists expect this tightening cycle to begin from December this year, driven by rising inflation pressures and reconstruction activity. However, this will depend on how the economy develops in the aftermath of the earthquake. 

ANZ - Khoon Goh
Bottom line: We have pencilled in the first rate hike for December 2011, given our view that inflation will prove less benign than the RBNZ has projected, and that the economy has the potential to turn more sharply in the latter part of 2011.

• The RBNZ views the inflation picture as somewhat benign (in fact inflation is not even mentioned in the policy assessment at all), giving scope for additional policy support. The fact that borrowers currently have a short duration of debt gives the RBNZ comfort that looser policy now can quickly be reversed if required. However, this is not without risk.
• Understandably, the level of uncertainty over the economic outlook is far greater than usual. Economic activity will rebound when the earthquake rebuild commences, and when this occurs will be a key judgement.
• Policy looks set to be on hold for most of 2011.
• The RBNZ’s projections flag a succession of 25bp hikes from early 2012 – a faster pace of tightening than expressed 3 months ago, but with a similar endpoint.
• We expect a marginally earlier unwind of policy support relative to the RBNZ. Key differentiating judgments here are that inflation pressures in 2011 are more pronounced than the RBNZ’s projection, and the current earthquake rebuilding response will be quicker than the September experience. Despite more cautious behaviour expected on behalf of consumers, financial conditions are now so supportive that the New Zealand economy has the potential to turn very sharply in late 2011. This effect is broader than and in addition to the pending reconstruction-related boost.
• The pre-emptive nature of today’s cut also suggests that the RBNZ is anticipating some weak economic data, which is expected to appear over the next few months. As such, economic activity would need to deteriorate markedly in order for the RBNZ to ease rates further. We think the odds of this are small, and in subsequent commentary the Governor pretty much ruled out the potential for a further cut.
• We see policy as now on hold, and the RBNZ will be in data assessment mode. We have pencilled in the first rate hike for December 2011, given our view that inflation will prove less benign than the RBNZ has projected, and that the economy has the potential to turn more sharply in the latter part of 2011. Indeed, a combination of the Rugby World Cup activity, the ramping up in reconstruction work and the diffusion of a massive terms of trade boost looks set to boost economic activity late in the year. 

Economists are concerned the Reserve Bank is paying too little attention to inflation risks after it cut the official cash rate half a percentage point in response to last month's devastating Christchurch earthquake.

Today's move returns the OCR to the record low level in place between April 2009 and June 2010, put in place to combat the recession of 2008-09.

In its quarterly monetary policy statement (MPS), the Reserve Bank said the earthquake would clearly have a negative impact on activity in the near term.

"It is difficult to know how large or long lasting this impact will be, but there is a risk that the downturn is quite severe. To guard against this risk it is appropriate for monetary policy to become more supportive," the MPS said.

"Lowering the OCR should be regarded as an insurance measure, designed to help offset the negative effects of the earthquake until such time as rebuilding -- and a recovery in the broader economy -- act to draw on the economy's surplus resources."

A preference by borrowers for floating rate mortgages meant any move in the OCR translated relatively quickly to the interest rates actually faced by households and firms, the MPS said.

"The (Reserve) Bank can ease policy knowing that the resultant reduction in effective interest rates can be reversed quite quickly once the economy begins to recover."

ANZ chief economist Cameron Bagrie and head of market economics and strategy Khoon Goh said their view was that inflation would prove less benign than the Reserve Bank had projected.

There were clear upside risks to the Reserve Bank's inflation forecasts in the near term, stemming from higher energy prices, they said.

The Reserve Bank's medium term inflation forecasts, which settled around 2.2 percent, looked far too light given the known looming upside pressures to prices.

The economy also had the potential to turn more sharply in the latter part of 2011 than the Reserve Bank was expecting, the ANZ economists said.

"Indeed, a combination of the Rugby World Cup activity, the ramping up in reconstruction work and the diffusion of a massive terms of trade boost looks set to boost economic activity late in the year."

BNZ head of research Stephen Toplis said he was "a bit concerned" that the Reserve Bank spent little time discussing the inflationary impact of the earthquake.

"Fundamentally, we believe that the earthquake has significantly raised the inflationary pressure on the economy as it is as much a supply shock as a demand shock," Mr Toplis said.

While the Reserve Bank had chosen not to publish many of the forecasts it usually did in an MPS, it could be concluded it was forecasting around no growth in the December quarter of 2010 and a small negative for the March quarter of 2011. Some momentum turned up in the 2011 June quarter and then very strong growth was forecast in each of the next five quarters.

The Reserve Bank said it had reduced the economic projections in today's MPS because following the earthquake it had needed to make many important assumptions based on quite limited information.