Time for Normalisation?

BNZ Head of Research Stephen Toplis contemplates the Reserve Bank's next move and suggests maybe it it time for normalisation.

Monday, November 6th 2017, 4:42PM

by Stephen Toplis

It is our strong view that the RBNZ needs to adopt a formal tightening bias when it releases its November Monetary Policy Statement this Thursday. It should probably back this up by moving its first published tightening forward from December 2019 to earlier in the year. But while we would strongly recommend this course of action we would not be especially critical of the Bank if it, instead, hid behind the wall of confusion that currently surrounds it for a while longer.

To us the confusion lies with the detail of upcoming policy changes that the new government will implement. We all know the broad thrust of the changes but, at this stage, need a bit more detail on timing and specifics before including such change into our models. Moreover, incorporating change can take a fair few person-hours of analysis and the folk at the RBNZ really haven’t had that much time available to them.

While the lack of detail may add to forecast confusion, the Bank does know the broad thrust of policy and will be keen to take a stab at its implications as soon as possible so don’t be surprised if some effort is made to either explicitly include some policy changes or, at the least, talk of the risks of such to the Bank’s central forecasts.

We do not buy, however, the argument that the RBNZ would sit on its hands because it doesn’t yet know the exact detail of the future Policy Targets Agreement or, indeed the Reserve Bank Act. Sure, there is some uncertainty about the detail but, equally, there is a great deal of certainty too.

Employment will enter the equation. But if it does so, it is highly unlikely to prevent the RBNZ from becoming more hawkish as the unemployment rate looks set to sit near to, or perhaps even below, the NAIRU.
If the Reserve Bank was to stand pat until the new RBNZ Act is finalised it might have to do and say nothing for another 18 months. This would be completely inappropriate.
CPI inflation will remain a key, probably THE key, focus of the RBNZ Act so the Bank will still want to respond to inflation developments.

On this basis, if the Bank concludes that inflation is not an issue then it might well reiterate its previous statement but it won’t do this simply because of uncertainty around prospective changes to its objectives.

Moreover, don’t fall into the misapprehension that Acting Governor Grant Spencer will do nothing because of the temporary nature of his role. If he, and his fellow “committee” members, see reason to respond they will do so.

For the record, we expect that the new finance minister will wait for the new Governor to be installed and then sign a new PTA with an employment consideration in it in March of next year. In this interim way, employment would technically be a secondary objective subservient to inflation. After a full review of the RBNZ Act is completed, which is likely to take a year or so, employment is likely to be given equal status to inflation in the Act but, because there is unlikely to be a set labour market target, inflation objectives will still tend to dominate settings at the margin.

While we have significant doubt over what the RBNZ will do with its monetary policy guidance this week, we have little doubt it will revise its CPI inflation forecasts higher. The biggest influence in this regard will be the currency. When the RBNZ put together its August MPS it assumed that the NZD TWI would average 77.9 through the December quarter of this year and 77.6 for March 2018. Its assumed value for the TWI at the September quarter 2020 end-point of its forecast track was 75.4. Right now the TWI sits at 73.6! If the RBNZ doesn’t assume the TWI will appreciate from here, which seems likely, then its current level should add around 0.5% to its year-ahead CPI forecasts taking the forecast of annual inflation to around the 2.0% mark.

Moreover, the starting point for the Bank’s inflation forecasts is raised with September quarter CPI inflation coming in 0.3% up on the Bank’s expectations and the December quarter is looking to be equivalently above forecast. In some ways, these overshoots don’t matter much, especially if the Bank sees them as transitory but to the extent that they feed into inflation expectations and wage-setting behaviour they become more permanent in nature.

We also believe that, on balance, the policy suite of the new government will be seen as more inflationary than its predecessor. We have discussed this in length previously but in short:
-   the substantial moves in minimum wage must push overall wage growth higher;
-   lower net migration inflows will further put pressure on a tight labour market;
-   the regional petrol tax in Auckland will push the CPI higher;
-   increased construction demands will push the cost of construction upwards;
-   rents will rise as the cost of construction increases, more students look for rental accommodation and the rental warrant of fitness bites;
-   the overall fiscal impulse will be greater;
-   redistribution of income from those with a low marginal propensity to consume to those with a high MPC will push up aggregate demand.

There are offsets but they will only be partial in nature.

As already noted, the Bank will not have the level of detail optimal but it can’t just put its head in the sand and ignore these factors.

To cap things off:
-   expectations for global growth are strengthening;
-   central banks elsewhere are either reducing, or talking about reducing, current monetary stimulus;
-   bond yields are edging higher.

This is not to deny that there are factors pushing the RBNZ in the opposite direction.

Heading the list is the fact that “longer-term inflation expectations remain well anchored at around 2 percent”, and the RBNZ’s preferred measure of core inflation – the sectoral factor model – sits well below the mid-point of the RBNZ’s target range.
Additionally, the housing market is a tad-weaker than expected and construction is similarly softer. Indeed, we think the general growth outlook for New Zealand will be softer than the RBNZ has previously projected. In part because net migration is declining faster than anticipated and business confidence is under pressure.

But, on balance, we still think that the rising inflation story dominates.

Accordingly, we think the time is ripe for the RBNZ to talk about policy normalisation in much the same way as central banks such as the Federal Reserve (which, incidentally, has an employment objective too) are doing. This is not so much an argument that interest rates NEED to rise to choke off inflation. It is more an argument that interest rates don’t need to be at emergency-low settings when inflation appears to be returning to target.

We think there is now an air of inevitability about this transition. And we think, if pushed, the central bank will be hard pressed, at this juncture, to repeat its previous mantra that the chances of an easing are the same as the chances of a tightening. The worm, in our view, has most definitely turned. However, we do acknowledge the extremely difficult operating environment in which the RBNZ is operating and would not be completely surprised if it displayed a degree of caution in its attempt to come to grips with this transitional phase.

The RBNZ’s Monetary Policy Statement will dwarf all the other releases due this week but, for the record.

-   The RBNZ’s Survey of Inflation Expectations is released 3.00pm on Monday (today). We are looking for two year inflation expectations hanging above the 2.0% mark. We see this as being consistent with the RBNZ moving to a tightening bias but the Bank has largely dismissed this survey as having less importance, than it did previously.

Tuesday we get the Crown Financial Statements for the three months to September 2017 which will, hopefully from the new Government’s perspective, show that revenue flows are continuing at a pace that will fund future fiscal spending.
Wednesday morning we get the latest GDT (dairy) auction. We are expecting a further drop in this series which in turn will put more downward pressure on Fonterra’s expected payout and, in turn the NZD. Additionally, it may add to any downside risk perceptions that the RBNZ sees for the local economy.
Parliament also opens on Wednesday and we may get a bit more detail on the new government’s policies when the speech from the throne is delivered. Having said that, such speeches tend to be more about general policy thrust than specifics.
On Friday, we get Electronic Card Transactions for October. This series has been disappointing of late and is beginning to question the strength that we, and others, have built into our forecasts for private consumption. We are looking for a modest bounce in October. If this fails to eventuate, we may have to take another look at our near term domestic demand forecasts.

This piece was first published in BNZ's Market Outlook and is reproduced with permission.

Stephen Toplis is the head of research at BNZ.

Tags: BNZ OCR forecasts RBNZ Reserve Bank