Preview RBNZ MPS - August
Data Flash (New Zealand) - Preview RBNZ MPS - August Key Points
We expect the RBNZ to raise the OCR by 25 bps to 6.75%. However, that it is a very close call and we put a significantly higher probability on `at least one 25 bps tightening by 4 October'. The market is currently pricing zero change for 16 August and 10 bps for 4 October.
The fundamental reasons for a tightening remain strong, given the combination of a solid growth outlook and significant upside inflation risks . While it is increasingly likely that a small negative growth figure will be recorded for Q2, forward looking indicators suggest that the low point in the growth cycle has passed. Those indicators include continued strong import growth, a gradual upturn in job ads, as well as turning points in business and consumer confidence.
We expect the RBNZ to project quarterly growth rates of +0.1% and +0.5% for Q2 and Q3 respectively.
As a result of a significant depreciation of the NZD since the May Monetary Policy Statement, we expect the RBNZ to revise up its medium-term growth outlook. In terms of the medium-term output gap track, that provides an offset to the unexpected current weakness in activity.
Growth of 2.6% is likely to be projected for the four quarters to March 2001 (down from 3.5%), followed by 3.4% (2.6%) and 2.9% (2.6%) in the subsequent two years.
Such a growth track would be consistent with the NZD driven lowering of the Bank's overall MCI track by around 200-300 bps. The projected TWI track is expected to be revised down by 4-6% compared to the May outlook.
The growth outlook will have reinforced the RBNZ's concerns about potential second-round price effects from the near-term spike in inflation, which is being driven by the weak NZD, high world oil and other commodity prices, as well as tobacco tax increases.
As foreshadowed by Dr Brash last week, the Bank will project inflation to reach around 3% in late 2000. We expect inflation projections of around 2% p.a. and 1.5% p.a. for the two subsequent years - based on the assumptions of a gradual NZD recovery, falling oil prices, and no major second-round effects from the 3% spike.
The potential continuation of NZD under-performance and rising wage inflation as a result of changes in the industrial relations framework are the key risks to the inflation outlook.
Given the inflation outlook and the NZD weakness (the NZD is currently trading 8% below the May projections), we consider it very unlikely that the RBNZ will lower its previous projection of 90 day interest rates tracking up to 7.5% by mid-2001.
Dr Brash's speech of last week appears to have been interpreted by some commentators as an indication that further rate rises may not be necessary if there are no second-round inflation effects. However, we believe that Dr Brash meant to say that increases over and above what was foreshadowed in May would not be necessary.
With strong fundamental arguments for a significant further tightening over time, the issue becomes one of appropriate timing. The RBNZ will be very concerned about an adverse FX market reaction to a tightening, which would be driven by the view that the economy is too weak to sustain higher rates. However, such considerations are unlikely to ultimately dominate the RBNZ's decision-making, given that they imply giving too much weight to data reflecting recent economic performance rather than to the outlook. That increases the risk of acting too late - as happened during the tightening phase in the early 1990s and the easing cycle in 1997/98.
We expect the Bank to have come to the conclusion that the current situation (significant inflation risks, weak NZD, solid growth outlook) allows little room for error. Therefore, even if there remains uncertainty about the near-term strength of the economy, the argument for an insurance tightening is strong.
Expected Market Reaction With no tightening priced in, a 25 bps move on 16 August would lead to a sell-off in the bill contracts, particularly at the front end. The bond market reaction is likely to be muted, with scepticism remaining about the strength of the economy and the credibility of the tightening. Similar sentiment may lead to an initial weakening of the NZD, with a gradual recovery over the following week - similar to the AUD following the RBA action last week. Even if the RBNZ does not act on 16 August, the Statement is likely to be relatively hawkish in preparation for a move on 4 October. While the market may remain sceptical about the RBNZ's view of the world in that case, we would nevertheless expect a modest upward correction in bill yields. Bonds and the NZD are unlikely to react in any significant way.
Ulf Schoefisch, Chief Economist, +64 9 351 1375
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