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Tightening on 29 Sept. would risk RBNZ Credibility

Economic Note (New Zealand)

Deutsch Bank
Tightening on 29 September would risk damage to RBNZ credibility
Tightening on 29 Sept Would Risk Damage to RBNZ Credibility

#The RBNZ's new framework

In early February of this year, the RBNZ announced that it was moving away from a "strict" MCI framework and would instead explicitly target short- term interest rates via the Official Cash Rate. This followed discomfort with the fact that currency volatility was being transmitted onto interest rates via the MCI. This discomfort stemmed in part from research that suggested such volatility was counterproductive. It was often the case that the interest rate move triggered by the currency was in the wrong direction.

RBNZ research suggested that rather than requiring interest rates to move in reaction to the currency, the RBNZ should consider whether an adjustment in interest rates was necessary after looking at all the relevant economic variables including the currency.

While the currency would still play a major role in the RBNZ's determination of monetary settings, its day-to-day influence on interest rate settings was to be reduced.

In line with this, the RBNZ announced it would review OCR settings only every 6 weeks. These reviews would include the four monetary policy statements, when a full set of forecasts was undertaken, and four additional "interim" reviews. The Bank has emphasised that OCR movements in the interim reviews would only happen under exceptional circumstances.

#Tightening on 29 September could cause higher risk premium on NZ assets

There seems little doubt that the MCI "experiment" was costly to the RBNZ's credibility. Many investors expressed considerable disquiet about the framework, which they found confusing.

As a result, the RBNZ's move away from the MCI framework to a cash rate regime was favourably received. In making the move, the RBNZ made much of its research suggesting the new regime could lead to superior outcomes over the MCI framework - at least in terms of lower instrument variability.

It is important that the RBNZ now build confidence in the new regime. Unfortunately that confidence has already taken a hit, with the market surprised by the hawkish tone of the August Monetary Policy Statement compared to May.

Arguably the market overreacted to the RBNZ Statement. RBNZ forecasts are always conditional on the data and can change considerably in a short space of time. Be that as it may, investor feedback since the RBNZ Statement has been very negative and the NZ bond market has performed poorly. NZ long bonds have not gained as a result of the RBNZ's desire to be pre-emptive, while the NZD has come under downward pressure despite higher short rates.

A tightening by the RBNZ on 29 September could have a similar impact on the NZ market. For the RBNZ to tighten rates after a relatively short period of currency weakness would fly in the face of the research published by the RBNZ in recent times. This research has made much of the fact that "interim" movements in monetary policy (i.e. those that don't involve a full review of the forecasts) are often mistakes. The RBNZ has also stated that lower inflation expectations allow the Bank to be more considered in its assessment of policy settings

The new OCR regime has only been operating since March. It is important for the support of the regime that the reasons for the first move in the OCR be clearly identified. Since the September review of the OCR does not occur against the backdrop of a full-scale update of the economic outlook, the reasons for such a move could be questioned. Such a move also risks setting a precedent and will raise the focus on the interim reviews.

Given these factors, an increase in the OCR on 29 September could damage the RBNZ's standing and lead to a further increase in the risk premium on NZ assets.


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