RBNZ Preview: Q4's soft CPI numbers threaten NZ's rate outlook

The Reserve Bank of New Zealand surprised the market last month by maintaining a more hawkish stance than the market was expecting. The introduction of one line in last month’s policy statement from Governor Wheeler expressing that further increases in the OCR will be required caught the market by surprise, despite the fact that the bank pushed out its expectations for interest rates by adjusting its 90-day bank bill forecasts, which indicate that the RBNZ will add another 80 bps to the OCR over the next 3 years, down from 110 bps in the prior MPS.

Another policy meeting, more dovish expectations from the market

This time around the market is also expecting a more dovish tone from the RBNZ and for broadly the same reason; a lack of positive inflationary pressures. Falling commodity prices, particularly for oil, and generally soft global inflation are weighing on the outlook for consumer prices in NZ. This is causing the market to readjust its prior assumptions about the possibility of interest rate hikes this year. In fact, the market now broadly expects no action from the central bank until 2016.

Big miss from Q4’s inflation numbers

Earlier this month Q4 inflation numbers for 2014 were released, and they were not pretty. Consumer prices fell 0.2% last quarter, down from a 0.3% gain in the prior quarter. Headline inflation now resides around 0.8% y/y, which is below the RBNZ’s official 1-3% target range, hence the decision by the market to price out the possibly of any increases in the OCR this year. However, a lot of the softness in inflation can be attributed to falling oil prices, which is actually a broad positive for the NZ economy.

Other economic data out of NZ recently has been broadly positive and this should be reflected in this week’s policy statement from Wheeler. Towards the end of last year consumer and business sentiment strengthened even more and other economic indicators also continue to point to trend or above trend economic growth this year. A softer exchange rate and an improving terms of trade also bodes well for the commodity based economy.

The time is right to do nothing

When the mild inflation outlook is combined with a positive outlook for the economy as a whole, it’s the perfect recipe for stable interest rates, thus it’s likely that the RBNZ will leave the OCR at 3.5% this time around. At present, the bank’s own forecasts suggest that it will raise the OCR one more time this year. As we have already stated, a softer inflation outlook due to falling oil prices has eliminated the need for further increases in interest rates at this stage, thus we expect the bank will adjust its bank bill forecast to reflect this, although we may have to wait until March which is when the next MPS is released (there isn’t a monetary policy meeting scheduled in NZ during February).

Market reaction

We expect the RBNZ to reaffirm its positive outlook for the economy while adding that only modest inflationary pressures are affecting the outlook for interest rates. If the bank removes any strong references to further OCR increases it may act as a confirmation to the market that it isn’t planning on raising the OCR at all this year, which would likely result in another bout of NZD selling.

However, the vague nature of the RBNZ’s prior line about “some further increase in the OCR is expected to be required at a later stage” leaves the door open for the market to be surprised once again. The market is beginning to price-in the possibly of interest rate cuts this year, but the RBNZ may still believe that its next move will be to raise the cash rate, albeit not for a while.