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RBNZ Policy Statement and Q2 Wage Data

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RBNZ Policy Statement and Q2 Wage Data

Key points

The RBNZ left the official cash rate unchanged at 6.5% - a level the Bank considers broadly neutral. Uncertainty about the economic outlook has been the key reason behind the RBNZ's decision.

Consistent with a downward revision in the near-term growth track, the RBNZ has lowered its medium-term projections for the 90 day rate from 7.5% to 7.2%. Growth for the four quarters to March 2001 is now expected to be 2.0% (down from 3.5% in the May forecasts). The outlook for the subsequent two years has been revised up to 3.4% and 2.9% (from 2.6% for both years).

The RBNZ has given significant weight to the weakness in business and consumer confidence in projecting the near-term growth track.

Due to the combined effects of world oil prices, the weakness in the NZD, as well as the rise in tobacco taxes, the annual rate of inflation is forecast to peak at 2.9% in late 2000 (1.8% in the previous forecast), before falling back to 1.4% over the following year.

The TWI is projected to appreciate by more than 10% over the next two years - which is a key assumption behind the projected decline in inflation in 2001. No significant second-round effects from the near-term inflation spike have been assumed.

Our assessment

While the Statement was significantly more dovish than expected, we believe the RBNZ made the right decision in keeping rates on hold at this point. However, we see significant upside risks to the medium-term inflation outlook, which will eventually trigger a RBNZ re-think.

Early indicators are hinting at a potentially faster rebound in activity than assumed in the Bank's forecasts, which, in conjunction with the continued depreciation of the NZD, will put upward pressure on inflation in 2001. Today the TWI has been trading around 2% below the updated RBNZ assumption - with little prospect of a turnaround.

We expect the RBNZ, based on the trend in the data over coming months, to come down on the side of a more bullish growth and less favourable inflation scenario in its December forecast. That is likely to lead to a 25 bps rise in the cash rate at that point. No move is expected for 4 October.

Market reaction

The NZD initially softened after the RBNZ statement from 0.4485 to around 0.4470, but strengthened later in the day to 0.4500.

Bill yields rallied by around 15 bps, with 5 bps and 20 bps now priced in for October and December rate hikes.

Short bonds rallied around 12 bps, while long yields were 2 bps lower. The RBNZ can afford sitting on the fence - for now

Based on available indicators, the RBNZ estimates that Q2 GDP contracted by 0.2% qoq. Given low business and consumer confidence, the Bank expects the soft demand profile to continue over the remainder of this year, with projections of 0.5% and 0.7% qoq growth forecasts for Q3 and Q4 respectively.

The Bank argues that businesses are currently delaying investment and employment decisions, due to uncertainty about the effect of government policy.

With respect to the medium-term growth scenario, the RBNZ noted that the economy has become the mirror image of the mid-1990s. This time it is the rural sector and exporters who are enjoying a period of relative prosperity, while urban New Zealand is struggling with flat or declining house prices, increased interest costs, increased petrol prices, and the higher tax rate on earnings over $60,000.

The Bank paints two possible scenarios for activity and inflation: `The higher inflation/tighter monetary policy scenario could readily flow from several sources. For example, the recent sharp fall in business confidence could prove to be very short-lived and of no lasting consequence for firm behaviour. In particular, investment intentions might revert quickly to the strong pattern evident earlier this year. The external sector drivers could prove to be more stimulatory than we assume in our central track, spilling over quite quickly into stronger domestic demand, just as they did in the early 1990s. In this environment, existing cost pressures might be passed through quickly and fully into price increases, and the assumption that the near-term blip in the CPI does not provoke a more generalised inflation cycle might prove optimistic.'

`Should reality turn out to be closest to this first scenario, we would probably discover that interest rates are still some way from the level necessary to maintain price stability over the medium-term, the more so if the exchange rate remained low. Moreover, if inflationary expectations were to rise in that environment, monetary policy in the future would have to work even harder. Under such a scenario, we could imagine the top of the interest rate cycle resermbling that of the mid-1990s.'

`By contrast, the lower inflation/easier monetary policy scenario would attribute much greater significance to the recent confidence shock. The confidence surveys could turn out to be early indicators of a sustained weakening in demand. In that event, we might expect investment and employment decisions to be scaled back and perhaps to remain at lower levels for an extended period.'

`The increase in interest rates could turn out to be impacting more than previously thought, in an environment where more debt is being carried by households and house prices are falling. It may also be case that we have overestimated the stimulus from the exchange rate, if `structural' reductions in the relative competitiveness of New Zealand exporting and import-competing industries have lowered the `equilibrium' exchange rate. This second scenario would probably imply the need for interest rates to fall from current levels over the next year or two.'

`Having considered these divergent scenarios in our assessment for this Statement, we have based policy on a central track that does not strongly emphasise one scenario over the other.'

The RBNZ's decision to not move was basically driven by the high degree of uncertainty about the outlook. We agree with the approach of giving the economy the benefit of the doubt at this point, although we expect data over coming months to confirm the first scenario.

Continued import growth, a gradual upturn in job adverisements, as well as early signs of a turnaround in confidence indicators suggest that the economy has already moved beyond the trough of the cycle.

On the inflation front, we see more pressure to come from the weak NZ dollar. While the peak in inflation may not necessarily be significantly higher than the 2.9% projected by the RBNZ for later this year, we expect a lagged currency pass-through to keep inflation above 2.0% for longer. The RBNZ's scenario of annual CPI inflation falling back to 1.4% within a year of the inflation spike looks a little too neat. Part of the RBNZ's projection is a 0.6% fall in import prices over the next year, which compares to our expectation of a 5% further rise on the back of more pronounced TWI weakness and a relatively slow retreat in world oil prices.

As a consequence, we expect that interest rates will have to rise to more than the 7.2% foreshadowed by the RBNZ. Even if the RBNZ's suggestion about the lowering of the equilibrium real exchange rate proves to be correct, the issue of the corresponding adjustment in the domestic price level remains. While the Bank should not stand in the way of first-round price effects associated with such an adjustment, it has to combat second-round effects. We believe that that cannot be achieved with interest rates only marginally above the estimated neutral rate of 6.5%. The RBNZ's argument that an output track close to potential will largely prevent cost pressure from being passed on seems somewhat implausible in that context. Businesses are working with very fine margins already and ongoing cost increases are a serious threat to financial viability for many. Recent evidence suggests that costs are increasingly being passed through in order to protect the bottom-line, even if there is the risk of losing business.

Consistent with the emergence of further evidence in support of the first scenario above, we expect the Bank to not only tighten in December, but to also revert to its previous interest rate projection of a medium-term peak at around 7.5%.

Wage inflation remains subdued

Average hourly earnings in the private sector rose by only 0.3% in the June quarter, following an upward revision of Q1 to +1.0% qoq. With the data significantly affected by compositional changes in the labour force, we caution against reading too much into quarterly movements. The annual increase in average private sector earnings was 1.7%.

Indicators point to a gradual increase in wage inflation to over 3% over the next year, which is consistent with the RBNZ's latest forecasts.

The Labour Cost Index confirmed relatively subdued wage trends. The index is based on a constant sample of jobs (and therefore does not suffer from compositional effects) and adjusts wage increases for changing job definitions or changes in productivity. That makes it a unit labour cost index.

The private sector labour cost index rose by 0.4% in the June quarter and by 1.3% over the past year.

While labour cost increases were subdued in the private sector, average public sector remuneration rose by significantly more, due to the second phase of adjustments in teacher salaries taking effect.

Ulf Schoefisch, Chief Economist, New Zealand,

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