The Direction Of Interest Rates In New Zealand
Data Flash (New Zealand)
NZ: Of Hawks And Doves: The Direction Of Interest Rates In New Zealand
16 February 2001
Summary This note identifies the key competing arguments that the RBNZ is likely to consider as it seeks to finalise the projections that will underpin its 14 March Monetary Policy Statement (MPS).
Given the predominant view that the US economy will begin to pick up later this year, we conclude that that the RBNZ is quite unlikely to ease monetary policy on 14 March - a view the market appears to be gravitating towards after contemplating well over 25bps of easing at one point.
More importantly, in sharp contrast to market pricing, we conclude that the RBNZ's projections will likely show the official cash rate (OCR) remaining at 6.5% for most of this year. Indeed, the RBNZ's projections will most likely suggest that the next move in interest rates will be a modest tightening, perhaps early next year.
Given current market pricing, such a projection could precipitate a sell-off at the front of the bond curve and a rally in mid-to-long bonds. This would occur if investors perceive an increased chance of large interest rate cuts further down the track based on the view that the economy will be driven into recession (a view more predominant amongst international investors than the domestic investor community).
If data released over coming months is weak enough to generate a consensus view that the US economy will not enjoy a `V-shaped' recovery later this year, but rather a more pronounced slowdown, the case for a modest rate cut would become more compelling. A rate cut might also occur if the RBNZ accepts the possibility of inflation well above the mid-point of its target range as the price of avoiding the risk - however small - of a sharp decline in economic growth.
Prior to finalising its economic projections and policy assessment, the RBNZ undertakes a "Hawks vs Doves' exercise. The aim of the exercise is to tease out all of the competing arguments for either tightening or loosening monetary policy. We expect to release our quarterly Economic Forecast towards the end of this month. Clearly these forecasts are contingent on our view of how the RBNZ is likely to interpret economic developments and thus set monetary policy over the period ahead. Therefore, we have conducted our own `Hawks vs Doves' exercise to help us to identify the key arguments that the RBNZ is likely to consider as it finalises the projections that will underpin its 14 March Monetary Policy Statement. This note summarises the key points. We begin with the dovish view.
The Dovish View
The starting point for the dovish view is recent developments in the US economy. In what follows, we consider the chain of thinking that underpins this view.
The US economy will remain weak throughout 2001 The Dove believes that the US economy is now in recession. Moreover, despite an extremely rapid easing in monetary policy, the US economy is unlikely to pick up significantly before the end of this year. Domestic demand is constrained by a gradual process of adjustment to correct the US current account deficit and the loss of wealth stemming from the overdue collapse in tech stocks. Inventory correction and a shake out in the labour market will also delay any upswing. In short, the Dove rejects the notion that the US will enjoy a `V-shaped' recovery later this year, preferring a more `U-shaped' profile instead.
A weak US economy will lower growth in many of New Zealand's other trading partners.
Given the position of the US as the world's largest economy, weak US growth will lead inevitably to slower growth elsewhere. A slower US tech sector could have major implications for Asia in particular. The Dove would also highlight the implications for Australia - a key export market for New Zealand's manufactured goods, and an economy already slowing of its own accord. Lower global growth will undermine New Zealand's export-led recovery A chart depicting the relationship between NZ and US growth over the past 20 years takes pride of place in the Dove's chart book. Although the relationship through the 1990s is less impressive than in the 1980s, the Dove concludes that the New Zealand economy will slow sharply. Slower US growth will have a negative impact on demand for New Zealand's exports, thus stifling New Zealand's emerging export-led recovery. Weaker growth in Europe, Asia and in Australia means further weakness in the demand for New Zealand's exports. Weaker world growth would also likely lead to a weakening in commodity prices, possibly harming New Zealand's terms of trade, with further flow-on effects on growth. In short, the Dove sees the New Zealand economy weakening as it did following the 1998 Asian crisis.
Lower economic growth will alleviate some of the RBNZ's concerns about inflation The Dove would acknowledge the high level of inflation pressure in the economy late last year, but would attribute it to a range of one-off factors that are unlikely to reoccur. Weaker world growth would put downward pressure on commodity prices, thus helping to reduce inflation. Further downward pressure might occur if the NZD strengthened significantly - something that may well occur if New Zealand interest rates were to be allowed to remain well above rates elsewhere. With the economy growing below its trend growth rate, the economy would begin to develop spare capacity. This would put additional downward pressure on inflation, thus clearing the way for lower interest rates.
In any case, the RBNZ has a duty to avoid unnecessary instability in output Even if there are some upside risks to inflation, the Dove points to the revised Policy Targets Agreement (PTA) which requires the RBNZ to achieve price stability while avoiding unnecessary volatility in output. Given the dovish view of the outlook for economic growth, the Dove argues that greater weight should be given to the output stability provision at the risk of temporarily high inflation. The RBNZ can't afford the risk of again being too slow to ease so soon after the policy mistake made during the 1998 Asian crisis.
Finally, even if the risk of the dovish view materialising is less than 50/50, the Dove argues that the RBNZ would be well advised to nonetheless adopt a dovish stance, even at the expense of risking an uncomfortably high inflation outcome. This RBNZ endured harsh criticism when it was too slow ease monetary policy following the onset of the 1998 Asian crisis. A repeat performance so soon after would be highly damaging to the Bank's credibility, and one that the Bank should seek to avoid at all costs.
The Hawkish View The Hawk challenges many of the points raised above. The Hawk also emphasises the differing cyclical position of the NZ and US economies and the fact that monetary conditions in New Zealand are already very stimulatory - more so than in the US. The hawkish view runs as follows.
The US economy is well set for a V-shaped recovery later this year The Hawk begins by suggesting that the predominant view is that the US will enjoy a `V-shaped' recovery later this year - a view seemingly endorsed by Fed Chairman Greenspan in his latest testimony to the Senate. Even Deutsche Bank, which has adopted a relatively bearish view of US growth prospects, sees US GDP growth returning to 3% by Q4 2001. In the eyes of the Hawk, the rapid easing in monetary policy and large tax cuts will be the catalyst for the turnaround. As in 1987, the economy will recover quickly from the fall in stock prices. The continued strength of the USD and commodity markets seems to reflect the V-shaped view, as do Consensus Forecasts.
A recovery in the US will underpin growth in New Zealand's trading partners, as will monetary easing elsewhere . With the US expected to recover and interest rates falling in those economies that are experiencing declining growth, the outlook for trading partner growth remains robust, albeit not at last year's stellar highs. Thus while acknowledging that, in the short term, New Zealand's exports will perform less impressively than they might otherwise have done, the Hawk believes that the medium-term environment for exporting remains quite favourable.
The correlation shown in the Dove's NZ/US GDP chart is too simplistic, as the experience during the 1990s demonstrates.
The Hawk rejects the simple correlation apparent between NZ and US GDP growth. Rather, many factors can act to disturb this relationship, as the experience of 1997/98 demonstrates. The key factors are the relative stance of monetary policy and existing differences in the cyclical position of the two economies. The Hawk believes that both of these factors will be very important going forward.
Monetary conditions in New Zealand are already very stimulatory Based on historical relationships, short-term interest rates at 6.5% in New Zealand and 5.5% in the US might be regarded a broadly neutral position. Given the cyclical upswing occurring in New Zealand, a further 100bps of difference between New Zealand and US rates can easily be justified, thus allowing New Zealand rates to remain unchanged even if US rates fall to 4.5%. Moreover, as result of the collapse in the NZD late last year, overall monetary conditions in New Zealand are already extremely stimulatory - and far more stimulatory than those in the US. Therefore, the Hawk concludes that it is simply wrong to focus exclusively on interest rates and assume that New Zealand needs to ease policy further to keep up with the US. Indeed, unlike in 1991, when monetary policy was still very tight almost two years after US growth began to slow, and in 1998, when the monetary conditions were slow to ease, the economy is this time well-placed to perform during a period of weaker world growth. .
The level of the exchange rate means that exports will grow despite the US slowdown.
Although acknowledging that growth in the global market for New Zealand's exports might be significantly weaker than the previous year - itself a 25-year record - the Hawk believes that the impact on export growth will be largely offset by the weak level of the NZD. A stimulatory NZD allows New Zealand producers to capture a larger share of the global export pie and compete more easily with foreign importers. The benefits of the weak NZD are only just beginning to be realised. Moreover, given pressure on profits in the US, the price competitiveness of New Zealand's exports might open up some opportunities that otherwise might not have arisen.
Even if the US slowdown is slightly more prolonged, lower interest rates in New Zealand will do little to help exporters.
The Hawk points out that lower interest rates in New Zealand will do little to help those exporters feeling the pinch from the temporary slowdown in global growth. Rather, the RBNZ can rely on the very rapid action being taken by the Fed and other central banks to underpin demand for New Zealand's exports. Moreover, by adding stimulus to the domestic sector of the economy at a time when it already appears set to recover strongly, the RBNZ might inhibit the current transfer of resources to the external sector of the economy, hurting New Zealand's longer-term growth prospects.
New Zealand is at different stage of the economic cycle, with a rebound in domestic demand imminent.
The Hawk is influenced by a range of economic indicators that point to the beginnings of a cyclical rebound in the New Zealand economy, reflecting easy monetary conditions and slow growth in mid 2001. Both consumer and business confidence improved sharply late last year. The rebound in confidence suggests a pick-up in consumer spending and housing activity is close at hand. The household savings rate appears likely to have increased by around 2pps over the past year. The rebound in confidence suggests there is considerable risk of a strong rebound in consumption over the first half of 2001. Representing close to 60% of GDP, this will easily sustain economic growth at its trend rate, if not higher, in the face of any slowing in export growth. The fall in housing market activity over the past year has been a significant factor underpinning weaker growth. Going forward, although weak migration flows continue to exert a downward influence at present, foreshadowed policy changes could see this influence reduce in importance later this year. In the near-term, anecdotal evidence suggests a strong lift in housing market activity in early 2001 due to the strong rebound in confidence and declining mortgage interest rates.
The labour market is already extremely tight Labour market data released over the past week has shown very rapid employment growth over the second half of 2000, in the Hawk's view, highlighting the huge difference between current economic fortunes and those in the US and Australia. As a result, the unemployment rate has fallen to a 12 year low. Even if the `natural rate' of unemployment has fallen somewhat, as seems likely, it remains the case that other skill shortage indicators are suggesting that the labour market is at least as tight as it was in 1995, a period which saw wage inflation accelerate to 4% yoy. Wage inflation looks set to rise significantly over the period ahead, with employees claims fuelled by the rise in headline inflation to 4% yoy. The latest data already provides evidence of a pickup wage settlements.
The NZD could under-perform market expectations in a V-shaped world The Hawk notes that a V-shaped recovery in the US economy could well see the USD regain its previous strength, thus undermining the projected recovery in the NZD. Thus it is premature to assume that a rising NZD can be relied upon to offset inflation pressures elsewhere in the economy. And a weaker than expected NZD would provide greater stimulus to the export sector.
Core inflation is set to accelerate Core inflation is already running at least 2% yoy despite last year's period of weaker economic growth. The Hawk's analysis of the economic outlook suggests that given current monetary settings, the economy would grow at least at its trend growth rate, suggesting little downward pressure on core inflation over the coming year. An easing in interest rates would increase the likelihood of above trend growth, perhaps driving core inflation moving up to 3% yoy by the end of this year. This would be highly damaging to inflation expectations, and would call into question the Governor's performance under the PTA. The Hawk concludes that there is no case for lower interest rates. Indeed, higher interest rates may be needed later this year, if not earlier (especially if the NZD remains week). The PTA also encourages stability in interest rates Finally, just as the RBNZ is required to avoid unnecessary instability in output, it also required to avoid unnecessary instability in interest rates. A rate cut now would likely need to be reversed later this year. It would be much better to leave rates at 6.5% - a level they have been at since May last year. What is the RBNZ likely to conclude? The RBNZ's world growth assumptions are normally derived from Consensus Forecasts. At least at present, the broad consensus appears to be that US economy will indeed enjoy a V-shaped recovery later this year. Importantly, this view seems shared by Fed Chairman Greenspan. Although it has done so on occasion in the past, we doubt that the Bank will depart from the consensus view on this occasion unless data released over the next two weeks suggests that a further significant reduction in the consensus view is imminent.
Clearly, forthcoming confidence, NAPM and payrolls data will be watched very closely (though the latter will come after the Bank's economic projections are finalised). If, as we expect, the Bank adopts the V-shaped recovery view, they are likely to project quite robust economic growth in New Zealand. This suggests that they will reject the dovish view and be sympathetic to the hawkish view.
Given the above, we remain very comfortable with our view that the RBNZ is unlikely to ease on 14 March. Indeed, after pricing well over 25bps of easing at one point, the market appears to be gravitating to this view. More importantly, in sharp contrast to market pricing, we conclude that the projections will likely show the official cash rate (OCR) remaining at 6.5% for most of this year. Indeed, the projections will most likely suggest that the next move in interest rates will be a modest tightening, perhaps early next year. ? Such a projection could precipitate a sell-off at the front of the bond curve and a rally in mid-to-long bonds. This would occur if investors perceive an increased chance of large interest rate cuts further down the track based on the view that the economy will be driven into recession (a view more predominant amongst international investors than the domestic investor community).
Of course, by the time the May Policy Statement, the relative merits of the hawkish and dovish views discussed above will be much clearer. Thus, a rate cut in May is still possible at that time if:
?data released over coming months is weak enough to generate a consensus view that the US economy will not enjoy a `V-shaped' recovery later this year, the case for a modest rate cut would become more compelling.
the RBNZ accepts greater risk of inflation remaining well above the mid-point of its target range as the price of avoiding the risk - however small - of a sharp slowdown in economic growth.
The latter might occur due to residual sensitivity to the harsh criticism RBNZ endured when it was slow to ease monetary policy following the onset of the Asian crisis in 1998.
Darren Gibbs Senior Economist (64) 9 351 1376
Ulf Schoefisch Chief Economist (64) 9 351 1375