The neutral interest rate, crazy inflation, 4x50bp hikes in a row, unemployment headaches and good value for money
The Reserve Bank (RBNZ) is expected to raise the official exchange rate (OCR) by 50 basis points in Wednesday’s review to 2%, the level the central bank currently views as neutral.
The neutral OCR rate is the level where it is considered neither stimulating nor constraining economic activity.
As ANZ economists led by Chief Economist Sharon Zollner have said, estimating the neutral interest rate is a difficult task at the best of times. And with the COVID-19 disruption “always all over the economic data”, it’s very difficult to pinpoint it precisely.
“However, we wouldn’t be too surprised if neutral interest rate estimates start to rise, given the sharp rise in inflation expectations here and abroad. And what the RBNZ thinks neutral really matters , as they must lift the OCR one-to-one with any increase in their estimate of neutral, otherwise interest rates may become more stimulus, even if the OCR remains unchanged,” the ANZ economists say.
Any upward revision to Wednesday’s monetary policy statement would increase the odds that the RBNZ is not done with 50 basis point hikes after next week, ANZ suggests. RBNZ increased OCR by 50 basis points to 1.50% when last revised on April 13.
As ANZ economists have said, the policy outlook becomes more nuanced once interest rates are back in contractionary territory, or above the deemed neutral rate.
“Underlying inflation is clearly way too high and wages are accelerating. But at the same time, the RBNZ is headed for a sharply slowing housing market. Our central forecast, which assumes no unpredictable downside risk materializes, predicts that the strong labor market will prevent economic momentum from being completely flattened by the housing downturn.”
“But falling house prices have the potential to reduce consumer spending, through wealth and/or confidence effects, and that’s a pretty nasty mix for the construction sector, with construction costs up 18% year-on-year in the first quarter, even as the end product (housing) loses value,” says ANZ.
“In short, we think the balance of risks around inflation and economic growth is likely to become less one-sided in favor of strong OCR increases in the second half of this year, and that should prompt the RBNZ to adopt a more considered basis points in the second half of the year, but from this starting point, the tolerance for upside surprises in inflation is zero.
Zollner expects an OCR peak of 3.5% in the current cycle early next year.
“Inflation is just crazy”
The SBA’s chief economist, Mike Jones, also expects a 50 basis point increase. This, he says, is almost entirely priced in by the financial markets. However, what is less certain is what the RBNZ does with its interest rate forecasts and forward guidance, which will determine Wednesday’s market reaction.
“Rising recession risks, globally and in New Zealand, cloud the picture a bit. These raise the difficulty rating for future RBNZ interest rate decisions, but, for For now, the focus will remain firmly on the current problem: inflation. Expect no quarter. The path of “least regret” for the Bank is always to bring the OCR to a neutral setting, around 2 .0%, quickly and smartly, and then take a more cautious stance from there.”
“This frontloading approach will be reflected in the Bank’s new OCR forecast track, which should show a much steeper ascent than the February monetary policy statement, but not necessarily a much higher peak. [of] 3.35% expected in February. Something around 3.5% maybe,” Jones says.
“It will also be interesting to know if the backend of the RBNZ OCR forecast takes into account the assumption of a possible easing cycle. The May statement will show forecasts until June 2025, so we believe that the track will tease possible cuts. The Bank will not want the market fixated on this aspect and lose some of the yield curve tightening. We still do not accept the full extent of this implied tightening given the traction that the Bank is already exerting is exceeding demand, and in particular house prices.”
ASB economists forecast a spike in OCR of 3.25% against market expectations of around 3.75%.
Jones says that while it can be argued that much of the inflation the RBNZ is fighting is beyond its control because it either comes from abroad or comes from supply shortages, New Zealand is in the midst of a negative supply shock on top of a positive demand shock. Annual inflation is 6.9%the highest since 1990.
“Inflation is just plain nuts and aggressive action is warranted to ensure it doesn’t embed in expectations, which would require a longer and more painful tightening cycle. The ‘dot in Bank’s time remains relevant.
If a 50 basis point raise is issued next week, the OCR will be at a neutral level, meaning the first part of the RBNZ’s job will be complete.
“From here, the least regret framework becomes more nuanced, requiring a more cautious approach as OCR enters territory on the tighter side of neutral. The Bank will likely adopt a more data-dependent approach as it seeks balance risk-restrictive inflation expectations, so we continue to expect the pace of July-November hikes to slow to the regulatory rate of 25 basis points per meeting. base in July, however, remains a reasonable risk and cannot be ruled out,” says Jones.
bang for money
Kiwibank chief economist Jarrod Kerr also expects a 50 basis point increase to 2%. He then expects 25 basis point hikes until the OCR hits 3% in November.
“And that should be enough. With real estate prices probably down 10% by the end of the year, and most of the mortgage portfolio will be re-priced by then, RBNZ gets what it pays for,” Kerr said.
According to RBNZ data, $206.5 billion, or 61.5%, of all residential mortgage debt will be affected by any rate increases over the next 12 months. This includes refixed mortgages and floating mortgages. As of March 31, there was a total of $335.447 billion in home loans outstanding.
Four consecutive increases of 50 basis points
Michael Gordon, Acting Chief Economist of Westpac NZ this week updated its forecast, which now include four consecutive increases in OCR of 50 basis points. After April’s increase and the one expected on Wednesday, Gordon expects further increases of 50 basis points in July and August, bringing the OCR to 3%.
“This was born out of two considerations. First, monetary policy settings are still far from where they need to be. We now expect the OCR to peak at 3.50% for this cycle, relative to to our previous forecast of 3.00%,” Gordon said.
“The second consideration was that the RBNZ’s change in tactics during the April review opened the door for larger OCR moves in the future. The April decision was described as ‘a point in the time saves nine” – early action to control inflation would reduce the risk of having to raise interest rates even higher in the longer term.”
“We agree with the reasoning behind this. There is understandably concern about the impact that higher interest rates will have on highly indebted homeowners, particularly those who have entered the market recently when the interest rates were at rock bottom, but the RBNZ would do them a disservice by accommodating them at first and then ultimately forcing them to raise interest rates well above what was considered the pain threshold,” says Gordon.
Westpac notes that house prices have now fallen for five consecutive months.
An unemployment puzzle
As announced earlier in the week, BNZ head of research Stephen Toplis believes that the RBNZ has no choice but to raise the OCR by 50 basis points on Wednesday. Toplis sustains lowest unemployment rate in decades, 3.2%is a bigger headache for RBNZ monetary policy than the highest inflation in 30 years.
“The task of the Reserve Bank is clear. At its most basic level, it must reduce current annual inflation from around 7% to 2% and it will require that the unemployment rate, currently at 3.2%, reaches around 4.5% to reach its maximum sustainable employment target.”
“The only way for the RBNZ to do that is to keep raising interest rates until it gets the boost it wants. And it will,” Toplis said.