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RBNZ Monetary Policy Statement - March 2000

Data Flash (New Zealand)
RBNZ Monetary Policy Statement - March 2000

Key points

The RBNZ raised the official cash rate (OCR) by 50 bps to 5.75%, in line with average expectations.

The projection of the future 90 day rate track was revised up, with a peak of 7.3% in early 2002 and only a very modest decline over the subsequent 12 months.

The track is consistent with the RBNZ expecting OCR to rise another 125 bps over the next year and by 25 bps over 2001/02.

We see significant upside risks to this outlook, given that the interest rate projections are based on the following assumptions:

- Relatively modest GDP growth over the next year despite monetary
:::::conditions assumed to remain close to their cyclical low. The
:::::RBNZ has revised down its forecast for the 2000/01 year from 4.2% to
:::::3.2% (Q1 over Q1), followed by 3.6% and 3.1% in the subsequent two
:::::years. A mildly positive output gap (rising from zero to 0.8% of
:::::GDP) is consistent with those projections.

- A 7% recovery of the NZD over the next year, which would more than
::::offset any effect from rising world price inflation.

Those two factors, in combination with a surprisingly benign wage track, have generated a relatively modest inflation forecast profile. The peak of 1.8% in late 2000 compares with a 2.5% projection for mid- 2000 in the November forecast - with a large part of the difference accounted for by a significantly lower than expected actual CPI for Q4/99. The RBNZ argues that some weight has to be given to the argument that inflation will be structurally lower going forward.

The market reacted strongly to the Statement, with 90 day yields down 5 bps to 6.22% and 10 year yields down 15 bps to 7.0%. The NZD sold off by around 30 bps to 0.4875 on the dovish inflation outlook.

In our view, there is a significant risk that the fixed market will reverse today's gains over the coming month as more evidence emerges that the RBNZ inflation outlook is too optimistic. Data published after the finalisation of the RBNZ numbers have already pointed towards higher inflation pressure. Import prices for Q4/99 and February commodity prices were above RBNZ expectations. Furthermore, the RBNZ concedes that, based on the latest manufacturing data, its Q4 GDP estimate of 1.0% qoq is too low.

Furthermore, we expect the Q1 CPI (to be published on 17 April) to be higher than the RBNZ expectation of 0.6%. That suggests that there is a high chance of another 25 bps tightening on 19 April, followed by a 50 bps move in May, particularly if the NZD maintains its lacklustre performance.

RBNZ March 2000 Projections (November projections in brackets)

:::::::::: CPIX (a%):::::MCI Index::::TWI Index::::: 90 Day %

H1/00:::::::::1.6::::::::::-350::::::::::54.4:::::::::: 6.0

:::::::::: (2.5)::::: (-175)::::: (56.5):::::::::(5.8)

H2/00:::::::::1.7::::::::::-150::::::::::56.0:::::::::: 6.6

:::::::::: (2.1)::::::::::(0):::::::::(57.9):::::::::(6.3)

H1/01:::::::::1.5:::::::::: 0:::::::::: 57.2:::::::::: 7.0

:::::::::: (1.6):::::::::(125)::::: (58.9):::::::::(6.6)

H2/01:::::::::1.6:::::::::: 100::::::::::58.1:::::::::: 7.2

:::::::::: (1.5):::::::::(175)::::: (59.5):::::::::(6.6)

H1/02:::::::::1.6:::::::::: 150::::::::::58.6:::::::::: 7.3

H2/02:::::::::1.6:::::::::: 175::::::::::58.8:::::::::: 7.1

Source: DB Global Markets Research, RBNZ

The RBNZ's real economy outlook

The RBNZ estimates that growth in Q4 was 1.0% qoq. However, latest indicators point to a higher outturn of around 1.5%, suggesting that the starting point for the output gap is somewhat higher than expected.

The RBNZ appears to attribute the stronger-than-expected growth performance in H2/99 (including the +2.3% in Q3) partly to timing differences in the recovery of the agriculture sector. That factor and the influence of a higher interest profile on the household sector is behind the downward revision of the growth outlook over the next 12 months from 4.2% to 3.2%. The magnitude of this change is surprising, given that the RBNZ lowered its assumption for the average level of monetary conditions by around 150 bps, which, according to the RBNZ's model, should correspond to about 0.5% extra growth per year.

The growth rate in potential output is forecast to average about 3% over the next few years. With growth of 3.2% next year and 3.6% and 3.1% during the subsequent two years, the output gap is forecast to rise from currently zero to about 0.8% over that period.

With the aggregate household debt level at around 100% of income and interest rates rising, the RBNZ projects a rise in household saving to restrain consumption growth to only 2.5% p.a. over coming years.

The competitive level of the exchange is forecast to generate a positive net export contribution in all three forecast years. As a result, the trade balance will improve markedly and the current account is expected to fall from a peak of 8% to 5.7% over the next three years.

The rate of unemployment is forecast to fall gradually further from currently 6.3% to 5.2%, compared with the trough of 6.0% recorded during the last cycle.

Deutsche Bank's forecasts, like the market average, are more positive about growth (4% over the next year), with household sector demand performing stronger and generating higher demand for imports. We expect the current deficit to improve at somewhat slower speed.

The outlook for inflation

We disagree with the RBNZ's inflation outlook, which shows inflation remaining close to the middle of the 0-3% target range over the next three years. From a `big picture perspective', that profile appears inconsistent with the fact that overall monetary conditions over the next three years are projected to remain in the lower half of the MCI range seen over the past 10 years.

The RBNZ devoted several pages to a discussion of the relevance of the `new paradigm' to New Zealand. Although no firm conclusion was reached, the published inflation outlook appears to carry significant new paradigm characteristics.

With the output gap already closed, the potential for growth to surprise on the upside, and clear signs of significant labour market tightness, we expect more domestic inflation pressure to emerge. The RBNZ's assumption of wage growth not exceeding 3% over coming years despite a significant fall in unemployment carries major upside risk.

The RBNZ also appears to have underestimated external price pressure, as evidenced by the fact that it assumed 4% import price growth (in NZD terms) over the year to March 2000. Following the 5.5% increase in Q4/99, which has been published too late for inclusion in the forecasts, an outcome closer to 10% appears more realistic.

Deutsche Bank's forecasts show inflation rising to 2.5% over the next year, with a subsequent moderation to 2%. That outlook is consistent with latest inflation indicators, including import prices, producer prices, and inflation expectations. It is also consistent with projections for other countries where rising commodity prices and a solid growth performance are expected to put upward on inflation over the next year.

Market reaction and outlook

We believe that today's rally in fixed interest markets has been overdone, given the upside risks to the outlook for inflation and the OCR. Factors that could lead to a revision to the RBNZ's outlook will be:

- Import prices: The RBNZ has already acknowledged that the Q4
:::::result was higher than expected.

- Export prices: The ANZ Commodity Price Index appears stronger than
:::::RBNZ expectations.

- Growth: The RBNZ noted, that, following the publication of the
:::::Manufacturing Survey, their Q4 growth estimate appears too low. The
:::::GDP outturn will be published on 27 March.

- CPI: We expect the Q1 CPI to marginally surprise the RBNZ on the
:::::upside, weakening the argument that the inflation process in New
:::::Zealand has changed. The RBNZ raised that possibility following the
:::::surprisingly low inflation outturns for Q3 and Q4 of 1999.

Finally, the NZD is likely to underperform the RBNZ assumption of an average TWI of 54.4 in H1/2000, suggesting that sufficient pressure will develop over the next month for a 25 bps rise of the cash rate in 19 April. We expect that to be followed by a 50 bps move in May.

As far as the NZD is concerned, the expected credit rating downgrade and the publication of a current account deficit figure of around 8% of GDP (24 March) is likely to weigh on the Kiwi over the remainder of the month. Some support may emerge as a result of positive monthly trade data and an increased focus on a potentially more hawkish approach to monetary policy in the next MPS in May.

Ulf Schoefisch, Chief Economist, New Zealand

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