How long will the Reserve Bank’s economic squeeze last?

I’m not a particular fan of the current regime at the Reserve Bank of New Zealand (RBNZ) which over the past few years seemed to me to have lost what I think should be its sole focus on maintaining price stability and has become somewhat distracted by various non-monetary issues.  Please don’t ask me about the Governor’s speech in June 2022 to the Central Banking Global Summer Meeting.

It is during this period that the RBNZ oversaw, if not instigated, near-record inflation – way, way outside its legislated target range – record (effective) money printing and more than an $8 billion loss on the mark-to market value on financial instruments it has purchased.  This is why focus is important.

But over the past few weeks I have thought about the RBNZ with some sympathies as it has approached its latest Monetary Policy Committee meeting.  Of course, by the time you read this article, its decision would have been made – right or wrong – but in my mind the current decision regarding the Official Cash Rate (OCR) and associated commentary was particularly difficult, and I would not like to have been in the Governor’s shoes in recent weeks.

Back in November 2022, the RBNZ’s OCR hike to 4.25% and hawkish rhetoric was probably quite a smart move, although to many observers it felt extreme at the time.  It certainly has left the RBNZ in the box seat now, able to react (as we saw on Wednesday) to incoming data and move in the required direction without needing to play catch-up.  Compare our position for example to that over in Australia, where the Governor of the Reserve Bank of Australia is under not inconsiderable political pressure to justify / maintain even a much lower 3.35% official rate that it’s reached already.

Consider the many factors at play at present and the environment in which we currently find ourselves weighing on the monetary policy outlook:

• Inflation data in the US not showing a rapid decline yet, more of a stabilization, and this an indicator of likely inflation behaviour here.
• Since the US Federal Reserve Chair Powell declared the “disinflation process has started” several weeks ago US 10-year yields are actually well up, as well as expectations of the peak Fed Funds rate. Huh?  US share prices are flattish and looking softer this week.
• Credit spreads (essentially the difference between corporate and sovereign borrowing rates) have come back a long way with the funding environment for big corporates in US/Europe looking a lot less stressed. This is an easing of financial conditions against the grain of what central banks have been trying to accomplish.
• In NZ we haven’t had much data lately apart from the influential “inflation expectations survey” which showed a modest downtick in two year inflation expectations from 3.6% to 3.3%. This survey is quite important to the RBNZ as it uses it to monitor whether inflation is becoming “sticky” and embedded into people’s behaviour. It would much rather this metric be closer to 2% before it can feel its job is done.

Adding to the mix in making this OCR decision even more difficult are these other factors with potential wildcard impacts:  what looks to be a relatively strong tourist season adding momentum to economic activity going into this quarter;  the construction activity pipeline projected to hit a wall much later this year; how hard and fast the migration tap gets turned back on; and the big one: election year!

And then of course the terrible cyclone has certainly thrown a spanner in the works in the past few weeks or so, and the magnitude of destruction that probably hadn’t sunk in even a few days ago, must now be front of mind.  The RBNZ will no doubt have been scrambling to update its models and projections, ahead of this week’s full MPS meeting.  To give some context, ANZ Bank’s projection shows a short-term hit to growth/inflation in the current quarter, followed by a net increase in economic activity as the rebuild starts.  Perhaps more stagflation, not exactly what the RBNZ wants when it is analysing the outlook, particularly when it may have felt economic data was on the verge of moving in its favour.

So to the actual OCR announcement a couple of days ago.   To me the 50bps increase this week was a no brainer in the current context of the factors outlined above.  This decision takes the OCR to 4.75%, with a likely further 0.25% in April giving a 5.0% OCR (note we won’t have Q1 economic data by the time of the 5 April RBNZ meeting, but maybe a slightly better idea of Gabrielle’s impact) which is certainly enough to constrain activity, remove money from the system and dampen inflation expectations.  May’s decision will then come down to how the economic data has unfolded over that period.

From a purely economic perspective I had thought a lower hike of +25bps this time around could arguably be warranted given the cyclone effects, but unlikely – the market would have taken that as extremely dovish and you would probably see unwanted (by the RBNZ) drops in mortgage rates etc.  Interestingly in the immediate wake of the cyclone, Kiwibank came out with the call that the RBNZ should halt all hikes. However tempting, this would be deeply problematic for the RBNZ’s credibility if such humanitarian concerns overrode the reality of the current inflation situation.  Finally regarding a +0.75% hike, there was simply no need for the “big stick” approach again, with the work that’s been done so far…and it also really wouldn’t wash politically which would still be an increasing and ever-present concern for the Governor.  The real question is not whether we top out at 5.0% or indeed whether we reach the 5.5% that the RBNZ has pencilled in for the OCR in the middle of the year.  It’s how long we need to stay there to really squeeze the economy.

Written by Warren Couillault and not ChatGPT…