Preview RBNZ Monetary Policy Statement
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Key data released since March - discussed further below - has pointed to stronger pipeline and medium-term inflation pressures than the RBNZ envisaged when preparing its last Monetary Policy Statement (MPS).
In such an environment, we expect the Bank will continue to move aggressively to remove monetary stimulus from the economy.
As a result, we expect the RBNZ to raise the official cash rate (OCR) by 50 bps to 6.5%.
Some commentators have suggested that weaker Q1 activity data justify a smaller rate rise. However, we assign only a 15% probability of the RBNZ opting for a 25bp hike.
Our view is that the prospect of further above-trend growth is not necessary to justify a 50bp move in the May MPS. With both product and labour markets already facing capacity constraints and pricing indicators pointing to strong inflation pressures, the need for accommodative monetary policy has clearly passed.
However, if, contrary to our expectations, weaker than expected data were to persist over coming months, this would have implications for the extent of additional policy tightening required over the remainder of the year.
We think that the RBNZ will regard an OCR of 6.5% as broadly `neutral', though the weakness of the NZD means that overall monetary conditions will remain accommodative.
Looking further ahead, we expect the Bank to project the 90-day rate rising to 7.6% over next year (compared to 7.3% assumed previously). Such a 90-day rate track would be consistent with a further 100bp rise in the OCR.
The higher track for interest rates is likely to be accompanied by a slightly stronger assumption of TWI appreciation. We expect the Bank to project an average TWI of 59.6 over the second half of 2002 (compared with 58.8 previously).
Despite the firmer track expected for monetary conditions, we expect to see an upward revision to the Bank's inflation projections (discussed in more detail below). The Bank's projections are likely to show inflation rising to 2% early next year (around 0.5 percentage points higher than projected in March) before gradually declining back to 1.5%by early 2002.
In terms of the risk analysis, the RBNZ is expected to emphasise uncertainty stemming from: the reaction of household spending to rising interest rates; developments in the world economy, including volatility in equity prices; the conditionality of the interest rate track on the recovery of the NZD; and possibly, the potential implications of a looser than previously foreseen fiscal policy stance.
Expected RBNZ Projections (previous projections in brackets) CPIX MCI TWI 90-day a% Index H1/00 1.7 (1.6) -300 (-350) 54.6 (54.4) 6.3 (6.0) H2/00 1.9 (1.7) -75 (-150) 56.3 (56.0) 6.9 (6.6) H1/01 2.0 (1.5) 75 (0) 57.6 (57.2) 7.2 (7.0) H2/01 1.9 (1.6) 200 (100) 58.7 (58.1) 7.5 (7.2) H1/02 1.6 (1.6) 250 (150) 59.2 (58.6) 7.6 (7.3) H2/02 1.5 (1.6) 275 (175) 59.6 (58.8) 7.5 (7.1) Source: DB Global Markets Research, RNBZ
* Likely Market Reaction
As always, the market reaction will depend heavily on the tone of the document as much as the specific forecasts. The Fed announcement some 3 hours earlier is likely to be at least as important for the direction of the NZD and bond market.
Of critical importance will be the emphasis the RBNZ places on the role of the NZD in containing inflation. The recent experience in Australia suggests that the market will not take kindly to an "explicit" link between the currency and the level of interest rates. Nonetheless, we think it reasonably likely that the RBNZ will make such a link. Any support the NZD may receive from an excessively hawkish RBNZ stance could soon be reversed on concerns that the Bank may push short term interest rates much higher than the market expects, leading to a sharp slowdown in domestic demand.
At the time of writing, the market was pricing in just less than a 50 bp move for next week. From that point the market is pricing in a further 75 bp increase in the 90 day bank bill, with the June 2001 contract implying a 90 day yield of 7.6% at that time. This is close to the level we think the RBNZ will project, implying a limited reaction in the futures market. However, the reaction of the currency will be the critical determinant of the movement in short term interest rates.
An unexpected 25 bp hike by the RBNZ would likely trigger an immediate rally in both short term and long term yields, with the fate of the currency ultimately the key to sustaining any rally.
We expect the longer end of the bond market to be relatively immune to the statement. While a hawkish statement may see some underperformance, concerns over the impact on the economy from an aggressive RBNZ stance should limit any widening in spreads to other markets. Indeed, a hawkish MPS may actually assist the longer end.
* The Bank's Revised Inflation Outlook
The Q1 CPI increase - at 0.7% - was 0.1% higher than the RBNZ's forecast. Nonetheless, somewhat perversely, the Bank is likely to have taken some comfort from this outturn. It will have reassured the Bank's economists that the inflation-growth relationship has not changed drastically as might have been suggested by the huge over- estimation of inflation during Q4.
Therefore, looking ahead, the Bank is likely to concur with our assessment that the data released since March has pointed to both stronger pipeline and medium-term inflation pressures than the RBNZ envisaged when preparing its Monetary Policy Statement (MPS).
Indeed, just a fortnight after the release of the MPS, RBNZ Governor Brash said `.if you had to put money on the probabilities, the whole market can see that, on the face of it, there may be more work for monetary policy to do over the next few months than perhaps seemed likely a month ago.'
The statement that accompanied the 25bp OCR tightening on 19 April provides pointers to the factors the Bank will use to justify an aggressive tightening profile. In its statement, the Bank noted that: The risks of rising inflation are gradually increasing. Although Q1 data has been softer, Q4 GDP figures pointed to strong broad-based growth. Growth prospects in NZ and abroad are at least as strong as the Bank expected in March. Surplus capacity in the economy has been more or less exhausted. The April rate hike was consistent with the Bank's previous projections showing that a firming in monetary conditions is necessary to maintain price stability.
* Growth, the Output Gap, and Unit Labour Costs
GDP growth grew by 2.2% in Q4, some 1.2 percentage points higher than expected by the RBNZ.
However, indicators point to a somewhat weaker Q1. At this stage we estimate growth of 0.6% in Q1 (prior to any adjustment for leap year effects). We expect that the RBNZ will lower it's estimate of Q1 growth (previously at 0.8%), but not by enough to eliminate the more positive output gap inherited from the previous quarter.
The fact that the Q1 QSBO showed capacity utilisation remaining at its elevated Q4 level is likely to have been of some concern to the Bank, strengthening its assessment that spare capacity in the economy has been exhausted.
As the Bank noted in April, growth prospects at home and abroad are at least as strong as when the Bank prepared it's March forecasts.
Although we expect the Bank to forecast a moderately firmer monetary policy stance, comments last week by Finance Minister Cullen suggest that the Budget (due mid-June) will reveal a more expansionary fiscal stance over the coming year than previously envisaged due to the front-end loading of the Government's spending commitments.
We expectation little change in the Bank's real economy profile going forward. This suggests that the Bank will carry a higher output gap through the forecast period. All other things equal, this alone might add 0.2-0.3 percentage points to its annual inflation forecast.
Labour market data due for release on Friday (to late to be included in the MPS) will provide further information on the state of the labour market and on whether tightness in the labour market is beginning to feed through into unit labour costs. Indicators of skilled labour shortages suggest that the trough in wage growth is likely to have been reached.
* External Prices
Export prices have been running slightly ahead of the RBNZ's March forecast. After moving sideways for a period, the world prices of New Zealand's commodity exports have shown renewed strength in recent weeks.
More significantly, the RBNZ substantially underestimated the strong growth in import prices recorded during Q4. Given our expectation of a further significant rise in Q1, we think that the Bank will be forced to raise its estimate of import price growth over the year to March 2000 by at least 3 percentage points, with this rise feeding through to higher inflation over the next year.
We expect the Bank to apply a slightly higher TWI starting point for H1/2000 of around 54.6 and then assume a slightly faster annual rate of appreciation than previously forecast. The inflation effect of this revised track plays a modest role in containing the greater than forecast upward pressures on inflation from higher world prices.
The RBNZ is expected to make small downward revisions to the assumed outlook for construction costs and rentals given ongoing weakness in the housing market.
Darren Gibbs, Senior Economist, +64 9 351 1376
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