Substantial RBNZ easing still likely – RBS

Research Team at RBS, suggests that the Reserve Bank of New Zealand remains set to undertake further substantial easing following the 25bps cut in its official cash rate to 2.0% this month.

Key Quotes

“Financial markets appeared disappointed the RBNZ did not cut interest rates by 50bps at last week’s meeting. The kiwi spiked to a new one year high above 0.73 against the US dollar immediately after the decision. Short term rates markets still have another 40bps of easing priced in for the next twelve months. But we expect the RBNZ will likely lower interest rates by another 75bps in the next two to three quarters.

First, the central bank retained its language from last month’s intermeeting update warning about currency strength limiting inflation: ‘weak global conditions and low interest rates relative to New Zealand are placing upward pressure on the New Zealand dollar exchange rate. The trade weighted exchange rate is significantly higher than assumed in the June Statement. The high exchange rate is adding further pressure to the export and import competing sectors and, together with low global inflation, is causing negative inflation in the tradables sector. This makes it difficult for the Bank to meet its inflation objective. A decline in the exchange rate is needed.’

Despite this month’s easing, the RBNZ’s 2.00% interest rate is far above any other G10 central bank with the RBA next at 1.50%. The central bank will therefore need to keep closing New Zealand’s interest rate differential in order to curb the kiwi and start pushing inflation back towards its 13% target range.

Second, the RBNZ remains concerned that sustained weakness in current inflation rates will drag down future inflation expectations. Annual inflation is expected to rise from the December quarter, reflecting the policy stimulus to date, the strength of the domestic economy, reduced drag from tradables inflation, and rising non-tradables inflation. Although long term inflation expectations are well anchored at 2 percent, the sustained weakness in headline inflation risks further declines in inflation expectations.’

Third, proposed new macro prudential measures to be implemented across New Zealand will take effect from October 1 rather than September 1 now but are still likely to increase the scope for the RBNZ to cut interest rates substantially from current levels.

Last, the RBNZ changed its forecasts in this month’s Monetary Policy Statement. It now projects the tradeweighted kiwi to fall only marginally from 76.0 to 74.5 over the next four quarters and for the 90 day bill rate to reach a trough of 1.80% by Q2’17. The latter is consistent with almost two rate cuts in the official cash rate from 2.00% given 90 day bills trade at a 25bps premium above the central bank’s benchmark rate. But the risk remains the RBNZ will need to ease further than it is implicitly forecasts as inflation continues to undershoot its projections.

In a Bloomberg interview on Friday, Assistant Governor McDermott indicated the central bank would like to wait until November 10 before easing policy again rather than cutting interest rates earlier at the RBNZ’s next meeting on September 22 – as officials preferred to change policy in conjunction with the central bank’s quarterly Monetary Policy Statements.

This would also allow policymakers to see Q3’16 CPI due on October 18 and Q4’16 inflation expectations on November 2. But McDermott also observed ‘you always keep open the option of your review because stuff can happen.’

The prospects of further substantial easing by the RBNZ coupled with less additional action now by the RBA are starting to support the Australian dollar-NZ dollar cross around 1.051.06. We see further strength in the cross as the RBNZ keeps easing policy in Q4’16 and again in the first half of next year, closing the gap between the two central banks’ benchmark interest rates.

In the week ahead, Q2’16 employment, July’s net migration and August’s consumer confidence data will be released in New Zealand.”