RBNZ Outlook: To Pause or Not to Pause?

Australia and New Zealand Economics Analysis

Although it is a difficult decision, my current prediction is that the Reserve Bank of New Zealand (RBNZ) will increase the Official Cash Rate (OCR) by 25 basis points during their May meeting which will occur on 24th of this month (May), which was previously postponed. Afterward, they will maintain the rate at 5.5% for the rest of the year. This memo will examine the dangers related to this projection and important factors to monitor.

The primary justification for the RBNZ to continue raising interest rates is that despite inflation and wages falling short of the RBNZ's February MPS forecast, they both remain at unacceptably high levels. Moreover, there are potential upward risks to inflation stemming from a tight labour market, inflation expectations, and the possibility of increased government spending outlined in the upcoming budget on May 18th. With market expectations already anticipating another rate hike in May, and the RBNZ's reluctance to tolerate prolonged easing in financial conditions (as evident from the April meeting), I believe the RBNZ is likely to opt for a final 25 basis point increase in May before indicating a hold on rates. Additional support for this decision includes: 1) emerging indications that the pace of decline in housing prices has recently slowed down (resulting in a projected smaller decline from peak to trough of approximately 20%), and 2) a significant increase in migration during the first quarter of 2023, posing an upward risk to rental inflation.

However, I consider a rate hike in May to be highly uncertain, and I estimate there is approximately a 30% likelihood of the RBNZ maintaining the current interest rate. There are noticeable indications that inflation is declining at a faster pace than anticipated, and leading indicators suggest further disinflation in globally traded goods as well as certain domestic aspects such as housing construction expenses. It is worth noting that the first-quarter CPI report demonstrated limited evidence of widespread inflationary pressures resulting from adverse weather events in Q1, which is promising. However, it is still premature to draw definitive conclusions at this stage.

Looking ahead, I maintain my belief that the New Zealand economy is more likely to experience a "soft landing" scenario rather than a recession driven by household factors soon. This is partly due to the significant support provided by strong net migration, which will help cushion aggregate consumption and housing demand in the coming months and throughout the next year. Considering the higher-than-expected net migration levels, surpassing both my own and the RBNZ's assumptions, I have revised my GDP forecast for 2023 upward by 30 basis points to 1.5%, while simultaneously lowering my growth projection for 2024 by 40 basis points to 1.4%.

RBNZ Outlook: To Pause or Not to Pause

I have revised my outlook, anticipating the Reserve Bank of New Zealand (RBNZ) to implement a final 25 basis point increase during its meeting on May 24th (previously expecting rates to remain unchanged). Subsequently, I expect the rates to be maintained at 5.5% for the remainder of the year. However, it is important to note that a rate hike in May is still uncertain, and I assign it approximately a 30% probability of the RBNZ keeping rates unchanged. In this analysis, I will explore the risks associated with my forecast and highlight key factors to monitor in the upcoming weeks.

Rationale for a May hike: The path of least resistance

As the New Zealand labour market displays ongoing resilience in the first quarter of 2023, characterized by robust job growth and an unemployment rate of 3.5%, coupled with market expectations of a 25-basis point hike, it appears that the RBNZ is inclined to pursue a final rate increase in May, following the path of least resistance.

To clarify, inflation is experiencing a more rapid decline than anticipated by the RBNZ, and there are also preliminary indications of decreasing wage pressure. In the first quarter of 2023, headline inflation (+1.2% quarter-on-quarter, +6.7% year-on-year) fell short of the RBNZ's February projections by 60 basis points, partly due to stronger-than-expected disinflation in the tradable sector. Core inflation has also moderated across various measures, including the RBNZ's preferred Sectoral Factor model, which displayed the first annual inflation deceleration in three years. Leading indicators persist in indicating further disinflation in the upcoming quarters, driven by factors such as a continued decline in global goods prices, a normalization in housing construction costs (which contributed over 1 percentage point to headline inflation in the past year), and indications that the previous acceleration in wage growth has likely come to an end.

Tarted to ease, albeit from high levels

Source: RBNZ, StatsNZ                                             

Exhibit 2: Lead indicators point to further disinflation ahead in categories such as housing construction costs

Source: RBNZ, StatsNZ

However, the task of the RBNZ to control inflation is far from complete, considering that core inflation remains at a high level, and there are still several potential factors that could lead to an increase in inflation. These factors include the persistent elevated level of wage growth, which has the potential to keep services inflation elevated for a longer period. Additionally, there are ongoing risks associated with inflation expectations, which could contribute to upward pressure on prices. Moreover, the impact of recent adverse weather events on inflation remains uncertain. Although I find some reassurance in the relatively mild inflation outcomes observed in key affected categories in Q1, such as furniture and furnishings (-2.9% quarter-on-quarter), property maintenance services (+0.1% quarter-on-quarter), and motor vehicle prices (+0.9% quarter-on-quarter), it is still too early to fully assess the extent of the floods' impact on prices.

Considering the upward risks to inflation and the RBNZ's evident aversion to easing financial conditions, it is highly likely that the RBNZ will opt to increase the Official Cash Rate (OCR) once again during the May meeting. This decision is partly influenced by the fact that wholesale interest rates have experienced minimal changes since the April meeting, yet they remain approximately 50-60 basis points below the pre-SVB peak. Any additional decline in rates from this point onward would pose a challenge to the RBNZ's objective of maintaining the current lending rates faced by businesses and households, which was the primary reason behind the RBNZ's 50 basis point hike at the April meeting instead of a 25-basis point increase. In a broader sense, my assessment of financial conditions in New Zealand indicates that they have recently been more accommodating compared to the previous range, and I believe the RBNZ would exercise caution regarding any substantial further easing of these conditions.

Moving forward, I will closely monitor forthcoming data releases pertaining to inflation expectations (due on May 12th) and the budget announcement (scheduled for May 18th). Regarding inflation expectations, I anticipate that the RBNZ will pay close attention to the way expectations are influenced by the aftermath of the cyclone and the subsequent reconstruction efforts, with a specific focus on medium-term expectations.

Inflation expectations due on May 12th

Source: https://www.finlogix.com/calendar

Two-sided risk: Inflation upside vs recession fearsConclusion

In my central scenario, I anticipate that the RBNZ will maintain the current interest rates beyond May and gradually initiate an easing cycle towards more "normal" levels in 2024. However, I acknowledge the existence of two-sided risks.

On the hawkish side, if inflationary pressures and wage growth persist, there is a possibility that the RBNZ may tighten monetary policy more aggressively than I currently anticipate. This could be driven by a larger-than-expected inflationary impact resulting from the cyclone rebuild, along with the risk of an increased fiscal impulse in the latter half of 2023. It is worth noting that the upcoming general election and recent tight polling results may prompt the incumbent Labour government to implement additional fiscal stimulus ahead of the election.

On the dovish side, there remains a chance of a household-led recession later in the year, as suggested by Goldman Sachs (with a 35% probability). In such a scenario, the RBNZ might cut interest rates earlier and/or at a faster pace than my current expectations. This could be triggered by a more significant adjustment in household consumption as more households experience higher mortgage rates (given the expected repricing for approximately half of mortgagees within the next 12 months). Additionally, if house prices continue to decline and have a more pronounced impact on wealth than I currently anticipate, it could contribute to a downturn in household spending.

This content may have been written by a third party. ACY makes no representation or warranty and assumes no liability as to the accuracy or completeness of the information provided, nor any loss arising from any investment based on a recommendation, forecast or other information supplied by any third-party. This content is information only, and does not constitute financial, investment or other advice on which you can rely.