Forex Investment and Currency Trading

NZ cash rates are a long way above real neutral

Reflecting increasing downside risk to activity stemming from a much weaker housing market, tighter credit conditions, and a deteriorating global growth backdrop, market brought forward the first rate cut to Q4 2008 from Q1 2009. An extra 50bp of easing next year is also expected, taking the cash rate to 6.25% by Q3 2009. In the face of continued above target inflation in 2008, 200bp of easing may look aggressive, but given that the real neutral cash rate is just above 5%, we would argue that such magnitude of easing is entirely feasible given the asymmetric risks to growth. The RBNZ has been rather quiet on the topic of neutrality in recent years. In part, this reflects a number of complicating factors including a longer and more variable lag time in the monetary policy transmission mechanism as households have shifted predominantly to fixed rate mortgages, consideration of a monetary conditions index which still factors into policy deliberations, and some difficulty in measuring inflationary expectations. The concept of neutrality is difficult and rather than putting a simply numerical figure on it, some central banks, including the RBA opt for a range (nominal 5¼-6¼% in the case of the latter). The RBNZ’s most recent musings on this issue (in the September 2003 Monetary Policy Statement) also nominated a range for the real neutral cash rate of 3-5%, noting that the range had fallen in recent years with estimates “centred a little below 4 per cent.” Well above its Australian counterpart, the premium may reflect NZ’s greater reliance on external funding, a more illiquid financial market, and a smaller & more open economy. Regardless, NZ’s real cash rate is arguable at least a full percentage point above neutral and, perhaps more importantly, coupled with the restraining influence of an elevated NZ$, monetary conditions are extremely tight.

Paving the way for substantial cuts and a lower NZ$

Accordingly, the odds favour a substantial easing cycle in 2009. While a cautious RBNZ is likely to want to see further signs of sustained sub trend activity and will probably also wait until it is confident that inflation has peaked (Q3/Q4 2008) before pulling the trigger, the risk is that it kicks off with a 50bp cut at the December MPS and frontloads its easing. Market expects the RBNZ to then deliver a further 150bp of easing to take the cash rate to 6.25% by Q3 2009 (200bp of easing). This would see the nominal cash rate move to its long run average by mid 2009, the real cash rate fall to neutral by Q1 2009, and then move into modestly stimulatory territory. We are assuming that the currency does some of the RB’s work in loosening monetary conditions and expect the NZ$ to fall to 0.6700 by Q1 2009.

While the AU market takes a reality check….finally

While the RBNZ is slowly but surely inching towards the start of an easing cycle, its Australian cousin clearly has no plans to join in the fun. This week’s prices data confirmed an uncomfortably high level of inflation with escalating pipeline pressures suggesting little relief in the coming months. Headline CPI jumped by 1.3% in Q1, taking the y/y rate to 4.2%, a decade plus high. More importantly, the various core measures also surged, rising by an average of 1.25% in the quarter to see the y/y rate accelerate to an average 4.25%, its fastest pace since the early 1990s. Price pressures were broad based reflecting an ugly combination of domestically generated inflation (housing, rent, electricity) and globally driven price increases (notably oil/petrol).

The confirmation of intensifying price pressures comes at a difficult juncture for the RBA amid increasing evidence of a moderation in domestic demand. Indeed, market expects next week’s key activity data (credit aggregates and retail sales) to print poorly and signal a very soft Q1 GDP. Accordingly, market does not think that the latest prices data will trigger further tightening in the near term. The RBA is in data watch and worry mode, hoping that the substantial tightening in financial conditions will generate a sustained slowdown while fretting about inflation from the sidelines. The odds favour an extended period of elevated cash rates at 7.25% but this remains conditional on a further easing in activity.