OCR decision: 3 reasons to cut rates and 3 reasons to hold

Tuesday, 13 August 2024

There's optimism Wednesday's OCR announcement will bring somerelief for businesses and consumers

ANALYSIS: Pressure on the Reserve Bank Te Pūtea Matua is building in anticipation for immediate interest rate cuts, but some economists say there are risks in taking the foot off the economic brake too soon.

Tomorrow, the central bank’s monetary policy committee will meet to review whether it has done its job in curbing inflation, which came in at 3.3% last month. As inflation inches towards the RBNZ’s 1-3% target, is it time for an early cut?

1) The case for a cut … Labour market pain

“Unemployment lifted quite quickly and will be above 5% very soon,” Kiwibank chief economist Jarrod Kerr said.

Last week’s labour market data showed the official unemployment rate was at 4.6% in three months to the end of June, up from 4.4% in three months to the end of March, which Kerr said is likely to keep impacting Kiwis in the year to come.

“Thousands of people are out of work. The RBNZ has inflicted enough pain on the economy to get the impact it wants.”

Kiwibank recommends an immediate rates cut, followed by consecutive cuts until the end of the year.

He said it takes 18 months for monetary policy to take effect, so the central bank “should be fixing policy today rather than next year,” as RBNZ indicated in May.

ASB senior economist Mark Smith said a retrenchment in hiring has means unemployment could hit 6% next year.

Research by the RBNZ on labour market impact on inflation should be enough for the central bank to take last week’s weak result into account this week and signal rate cuts, Smith said.

“Job listings will be down because during Covid, firms held on to labour. Now their profitability is very weak,” Smith said.

“The RBNZ is a bit more confident [in curbing inflation] and knows the labour market will get worse before gets better.”

Kiwibank chief economist Jarrod Kerr is calling on the RBNZ to start cutting interest rates immediately.

2) Cooling inflation

“Monetary policy has stronger impact on inflation than what we thought before,” Smith said.

The RBNZ forecast in May that Stats NZ would report annual inflation in the three months to the end of June fall to 3.6% from 4% in the March quarter. The actual result came in at 3.3% in June.

That means while inflation is at 3.3% now, it’s expected to fall below that later this year, Smith said.

Kerr said the central bank’s last set of hawkish forecasts assumed inflation would stick around for much longer, but has dropped to 3.3% which is close enough to RBNZ’s 1-3% range.

ASB senior economist Mark Smith says the labour market is a weak enough warning of worsening economic conditions.

“We think inflation will be at 2% next year, which points to rate cuts,” he said.

“Headline inflation has again surprised to the downside and is almost certain to be well within the RBNZ’s target band when the September quarter data are released,” BNZ head of research Stephen Toplis said.

“The economy is screaming out for relief and any further delay by the Reserve Bank risks it having to slash rates aggressively further down the track likely resulting in unnecessary volatility in output and prices,” Toplis said.

3) Markets and borrowers betting on a cut

Kerr said financial markets are already betting on an OCR cut.

“Banks have passed on some of the fall in wholesale rates because they’re not sure if RBNZ will cut rates. If they cut, there will be more immediate relief,” Kerr said.

Smith said 67% of market confidence is in the RBNZ cutting rates immediately.

He said a considerable drop in NZ yields may be due to an increasing likelihood that rates will drop soon.

RBNZ data shows a steady increase in the number of borrowers fixing interest rates for three months to a year since February.

Kerr said Kiwibank has seen about 70% of borrowers fixing for less than a year.

Economists say financial markets have already had a boost in confidence in anticipation of a rates cut.

“There is a risk in fixing for six months if interest rates go up. That is a possibility but we’re not expecting that,” he said.

ANZ chief economist Sharon Zollner said second-tier data like the primary manufacturing and services indexes have been weak this month.

“That has seen the market decide that the economy is much weaker than the RBNZ expected and it should cut immediately,” Zollner said.

But data on inflation, unemployment and GDP are more aligned with RBNZ expectations, which could mean the central bank will off for a while longer, Zollner said.

The case for holding off… 1) The central bank has options

“At this time of great uncertainty, if the OCR is held and [the RBNZ] points to cuts soon, that gives them every option from cutting rates in October to holding rates until February,” Zollner said.

She said the decision is a trade-off between certainty and timeliness: “The markets are punting on timeliness and we’re betting on certainty.”

ANZ chief economist Sharon Zollner says the RBNZ must consider all its options before making a decision.

Westpac chief economist Kelly Eckhold said there’s a “decent chance” the central bank won’t cut rates now but will trim the OCR to 5% by the end of the year.

Eckhold said the RBNZ will first consider how the housing market and business sector respond to falling wholesale interest rates.

“October is a safer bet. They might cut rates this week if they’re worried the labour market is weakening too fast,” however second quarter labour market data was in line with RBNZ expectations, he said.

2) Inflation uncertainty

Eckhold said the impact of recent income tax cuts are also only just taking effect.

“[The RBNZ] will be looking at the extent to which the economy responds to tax cuts. That is the most positive factor for consumer spending relative to last six months,” he said.

He said the tax cuts, which came into effect a fortnight ago, will only be seen in the economy for the first time in August.

Westpac chief economist Kelly Eckhold says the RBNZ must consider the impact of the budget and tax cuts before cutting interest rates.

“We expect that majority of tax cuts will be spent and there will be some impact on consumer spending.”

The central bank highlighted tax cuts as one of its points of uncertainty in May.

While the tax cuts are unlikely to have a big impact on overall GDP, Eckhold said the Reserve Bank needs to assess how much of an economic impact they will have.

He said the Reserve Bank needs to certain about the impact of the budget and Government job cuts before slashing interest rates.

3) Cancelled or deferred activity?

Zollner said the major strike against an immediate rate cut is the RBNZ’s initial forecast that it would start cutting rates next August - a year from now.

“That would be the most dramatic change in monetary policy stance ever seen,” she said.

“That only happens when there is a big economic shock, not just because the economy is getting tighter quicker than they thought.”

She said that while the central bank has “severely damaged the economy”, the downturn is still deliberate and policy-induced.

“Normally when the RBNZ starts suddenly cutting rates, its due to a global shock like the global financial crisis, or an earthquake or a pandemic,” Zollner said.

“This time we haven’t got any of this.”

The central bank now has the challenge of balancing a lack of sudden economic shock with the growing anticipation of business confidence.

“If the housing market gets a new lease on life due to rate cuts, they have a problem,” Zollner said.

“The question they have to ask is if they have cancelled economic activity or deferred it,” she said.

“If activity has been deferred, we might see things start to bounce bank quickly even before they cut the rate.”

Zollner said that while the economy is clearly weak, there is still “enormous uncertainty” about how vigorously it will rebound when conditions improve.

“There will be marginal extra pain in six weeks [to October],” she said.

“The market will continue to bet for rate cuts - that in itself improves confidence.”