In the final MPS of 2016, the RBNZ cut the OCR while flagging that further cuts could be likely.
However, the inflation outlook shifted significantly over the past three months.
As a result, the first MPS of 2017 saw the RBNZ shift to a neutral easing bias and signal distant rate hikes.
Looking back over 2016, low inflation and falling inflation expectations saw the RBNZ cut the OCR three times. At the same time the RBNZ maintained a distinct easing bias, reflecting the fact that the risks to inflation remained firmly to the downside. Oh how quickly things can change. Indeed, within a short period of time, the inflation outlook in New Zealand has shifted rather significantly. Q4 CPI, which was released on the 26th of January, showed that annual inflation had increased to 1.3% from 0.4% in Q3. This is the first time inflation had been back within the RBNZ’s 1-3% target band for the first time in over two years.
A key driver of the sharp lift in inflation was 2015’s petrol price falls coming out of the annual inflation calculation. However, underlying inflation pressures also appeared to be stronger than we had anticipated. Capacity constraints in the construction sector are continuing to push prices higher. Further, we saw signs that NZ’s tourism boom is also starting to put pressure on accommodation prices. Retail discounting was also less of a drag on inflation than it had been for some time, a signal retailers are getting some of their pricing power back. And while downside risks to the inflation outlook remain (in particular, the high NZD), the balance of risks around the inflation outlook have undoubtedly shifted in a reasonably short period of time.
As a result, the RBNZ found itself in an interesting position leading into its first Monetary Policy Statement (MPS) of 2017. After cutting the OCR by 25bp in November, the change in the balance of risks meant that the RBNZ was instead expected to provide some indication of when interest rate hikes might take place. The challenge for the RBNZ, however, was to deliver a neutral easing bias for the first time in over a year but, at the same time, to lower market expectations of imminent OCR hikes.
Market pricing had, in our opinion, got ahead of itself. Leading into February’s MPS, markets were pricing one OCR hike in 2017 and a 3% OCR by mid-2019. In contrast, our opinion was that the RBNZ would look favourably on the shift in the inflation outlook, but would not be going so far as to ‘bank’ the lift just yet. Indeed, the RBNZ surprised us on Thursday, with a weaker inflation forecast than we had anticipated from them, highlighting just how cautious the Bank remains on the inflation outlook.
Looking at Thursday’s market reaction, the RBNZ will undoubtedly be pleased with the outcome. Not only has market pricing for an RBNZ OCR hike by the end of 2017 fallen back to roughly 50% (from 100%), the NZD also moved lower. The RBNZ’s projections showed the OCR remaining at 1.8% well into 2019, with a 25bp hike built in by early 2020. The flagging of a distant tightening is more realistic than what market pricing had suggested, given the RBNZ remains concerned about the high NZ dollar and also sees the recent lift in long-term interest rates as an effective tightening. The RBNZ also noted premature tightening could undermine growth and stall the expected increase in inflation. We continue to view OCR increases as a long way off, towards the end of 2018.
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