Will Bollard reverse his 'emergency' interest rate cut?

Reserve Bank governor Alan Bollard is not short of advice as he ponders the next review of the official cash rate (OCR) due on Thursday morning.

However, that advice is sharply divided, between economists who say the governor should reverse the ‘emergency’ 0.5% cut he made in March after the February Christchurch earthquake, to those who argue he should leave it where it is but signal an earlier increase than previously signalled, to those who simply advise he should not change anything at all.

Arguments for either a hike next Thursday or at least a signal of a likely hike at the next review centre on the fact that the economic ‘emergency’ of March is over and in fact never really happened.

GDP growth has been ahead of the Reserve Bank’s –and everyone else’s  - expectations. 

An 0.8% increase in GDP in the March quarter (the average market economist forecast was 0.4%) and the revision of the previous quarter’s GDP rise from 0.2% to 0.5% means the economy is performing well ahead of what was anticipated.

That means “for its own credibility” the Reserve Bank has to bring any rate rises forward and reverse the March cut, said Bank of New Zealand head of market economics Stephen Toplis.

“The economy proved to be around 1.5% stronger over this period than the Reserve Bank had assumed when it cut rates. This is a massive difference over a short period of time…. there is simply no justification for the Reserve Bank to keep its ‘emergency’ rate cut and for consistency’s sake it must be removed as soon as possible,” he said.

A cut next week might be seen as too drastic, but signalling a change fairly soon, and raising it at the next review on 15 September – when the central bank will release a full monetary policy statement and an updated set of economic forecasts – would be wise, he said.

“We now believe the central bank will hike rates 25 basis points in September and then a further 25 points in October.

Less upbeat about the economic outlook, but also calling for a reversal of the March cut, is TD Securities strategist Annette Beacher.

The “emergency”, such as it was, is over, she said, and the central bank should either move the OCR back to 3% next week or give a clear signal it will probably do so in September.

However it should also signal this is merely a move back to “neutral” rates rather than the beginning of a tightening cycle, she said.

“The best accompanying signal would be that the cash rate can remain at 3% ‘for some time’ while the bank assesses whether the recent strength in activity and pace of inflation are temporary or ongoing.”

Other economists are holding to previous forecasts of no rate rise until December at the earliest, with some still saying increases are not likely until as late as March 2012.

There are three reasons to hold off, said JP Morgan economist Helen Kevans, who does not anticipate any rate increase until next March.

One is the ongoing global economic uncertainty, especially from the EU and US, and its possible impact on exports and other economic activity.

Secondly is a factor linked to the uncertainty – the high New Zealand dollar, which is keeping imported inflation down and is also acting as a brake on some export activity.

Thirdly is Dr Bollard’s own comments when he cut the OCR in March: that any increase would depend on clear evidence reconstruction is under way in Christchurch, and this has yet to eventuate.

Also in the cautious camp is Westpac chief economist Dominick Stephens, who is sticking to previous predictions of no OCR rise until December.

On their own, domestic economic factors such as GDP growth, business and consumer confidence surveys, and inflation, all point to a removal of the stimulatory level of the OCR sooner rather than later.

But the Reserve Bank cannot just look at those domestic factors, he said.

“Many other things have changed since March as well: the exchange rate is a lot stronger, the global environment looks more perilous, and commodity prices are softening. These factors can’t be treated in isolation.”

Next Thursday’s announcement will contain little change, he said.

“We expect the Reserve Bank to leave the cash rate unchanged at next Thursday’s OCR review, and to maintain its signal for a gradual tightening over the next couple of years.

“That could surprise markets, which have moved to price in earlier hikes.

“Markets are responding to news of stronger growth and inflation, but there are equally important off sets in the sharp rise of the New Zealand dollar and signs of slower growth among our trading partners.”