Weekly Economic Commentary 27 May 2024
Analysis and forecasts of the economy and markets, along with previews of data for the week ahead.
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This is what it sounds like when hawks fly
While delivering the expected on-hold decision at its May policy meeting, the Reserve Bank of New Zealand (RBNZ) hawked up its rhetoric and forward guidance. We continue to expect the first OCR easing in February next year, followed by gradual rate cuts thereafter. However, the tone of the May policy decision indicates the risk that easing comes later than we anticipate.
As expected, the RBNZ left the Official Cash Rate unchanged at 5.50% at its May policy meeting. However, in contrast to financial markets pricing for rate cuts by the end of this year, the RBNZ actually revised up its projection for the OCR and pushed out the likely timing of easings. The projected OCR path now peaks at 5.65% (vs. the peak of 5.60% assumed in the RBNZ’s previous February forecast). In addition, the updated path is not consistent with a cut until late 2025 (compared to mid-2025 previously).
Underlying the RBNZ’s more hawkish stance has been the lingering strength in inflation. The RBNZ now forecasts that inflation will end 2024 at a rate of 2.9%. That’s in line with our own forecast, but is considerably higher than their previous forecast of 2.5% inflation. On top of that, the RBNZ now expects that it will take even longer to get inflation back to the 2% target mid-point – the May MPS forecasts don’t have inflation back at 2% until mid-2026 (compared to late 2025 in their previous forecasts). That’s even with the upward revision to their OCR forecasts.
That upwards revision to the RBNZ’s inflation forecasts is mainly due to the strength of domestic inflation, which has clearly ruffled the feathers of the hawks at the RBNZ. Non-tradables inflation has surprised to the upside of the RBNZ’s assumptions for a year now, including a large 0.5ppt surprise in the most recent quarter. The minutes accompanying the May policy decision noted that “persistence in non-tradable inflation remains a significant upside risk.”
The RBNZ, like ourselves, expects that non-tradables inflation will drop back over the course of this year, but only gradually. While inflation in interest rate-sensitive areas of the economy (like the cost of property maintenance) is easing back, other prices like rents, insurance charges and local council rates have held at firm levels. Although these sorts of costs might be less responsive to changes in interest rates, those aren’t pressures the RBNZ can look through, especially as they can affect inflation expectations and operating cost more generally.
The RBNZ is now factoring in a more gradual easing in domestic prices. Even so, we still think the RBNZ could continue to be surprised to the upside on this front. That would be very important for the RBNZ’s stance over the coming quarters.
Balanced against that risk of persistent domestic inflation, imported inflation has fallen well short of the RBNZ’s forecasts. We expect that will continue to be the case over the coming year, and that will be important for helping to keep inflation expectations anchored in the face of lingering domestic pressures. Even so, it’s now looking like a longer road back to 2%.
The RBNZ has also revised its thinking in a couple of other key areas. First, the RBNZ’s growth forecasts have been revised down significantly, which helps them retain confidence that inflation will ultimately fall. However, that is balanced by a downgraded view of the economy’s productive potential, meaning the deflationary impact of slower economic growth is likely to be less pronounced than previously assumed. That judgement reflects the ongoing firmness in inflation despite recent softness in GDP, pointing to lower than assumed productivity in the economy.
Second, the neutral OCR has been revised up 25bps to 2.75% - this is a driver of longer-term OCR projections.
Finally, while Budget 2024 is out later this week, the RBNZ’s forecast for government expenditure is still based on the Treasury’s Half Year Economic and Fiscal Update 2023. The RBNZ raised the possibility that the timing of signalled changes in government spending and tax cuts might pose an upside risk to its forecasts for aggregate demand. That is, the impact of reductions in government spending to date (albeit those mainly initiated by the previous government) may already be reflected in indicators of activity (which the RBNZ has taken onboard in downgrading its forecasts), whereas impending tax cuts may not yet be factored into spending decisions. We’ll have more to say about our view regarding the impact of fiscal policy later this week in our coverage of Budget 2024.
Overall, recent developments have left the RBNZ with a more challenging inflation outlook –it wouldn’t take much for inflation to remain above 3% this year, especially with the risk of large increases in local council rates and tax cuts in the second half of the year, along with ongoing pressure on rents and businesses’ operating margins. Combined with the related risk for inflation expectations, there isn’t scope for the RBNZ to take their foot off the brake just yet. Consistent with that, the minutes accompanying the May policy decision noted that the Monetary Policy Committee discussed the possibility of tightening, while RBNZ officials have noted that interest rate cuts are not part of the current policy discussion.
The RBNZ’s updated thinking is very consistent with that in our recently updated Economic Overview – that is, there are still “hard yards” to be done to bring inflation down to the 2% target midpoint in a timely and sustainable manner. As a result, monetary policy will need to remain tight for some time yet. Our baseline view remains that the first 25bp policy easing won’t occur until February next year, to be followed by a series of gradual (once a quarter) 25bp reductions that will eventually lower the OCR to around 3.75% in 2026. That’s a later start to the easing cycle than implied by financial market’s pricing, which is consistent with rate cuts from November.
We now find a large gap between our own OCR forecast of an easing in February 2025 and the RBNZ’s August 2025 view, and there is some risk that our forecast proves to be too optimistic. With economic activity and the labour market cooling, another hike looks unlikely. However, should inflation pressures prove to be stronger than we or the RBNZ expects, the RBNZ may keep the OCR at its current level for even longer. We’ll make an assessment after reviewing the Q2 CPI in July and the RBNZ’s updated view in the August Statement.
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