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RBNZ surprise the markets with a low inflation forecast

Not sure whether the RBNZ wrong-footed the financial markets last week with their benign inflation outlook, or the markets wrong-footed themselves in expecting a change to the RBNZ’s forecast/guidance based on higher actual inflation to 2.20% and a lower TWI currency index? It was always going to be too early for the economic data to force a RBNZ change in stance. My take on the Monetary Policy Statement is that in a similar vein to Australian Treasurer Scott Morrison’s budget last week, there a few heroic assumptions made to get to the forecast you want. In the RBNZ’s case they must be assuming a higher TWI, no wage increases, reduced capacity utilisation, food price reductions and lower commodity/fuel prices to generate a forecast of annual inflation reducing from the current 2.20% to 1.10% by March 2018. The problem is that elsewhere in their economic prognosis through the statement they do not actually state that any of the aforementioned drivers of lower prices in the economy will actually occur. The RBNZ forecasts for the output gap and wage inflation on page 31 of the document show material increases, not decreases. Maybe Assistant Governor John McDermott’s speech today on forecasting will enlighten us. The RBNZ are basing their inflation forecasts on a stable TWI currency index at around 75 over the next 12 months, so no assistance from a higher currency value to drive lower imported product prices.

The lasting impression form the RBNZ update is that as inflation has been very benign for the last five years and that the RBNZ see that situation continuing going forward i.e. nothing much has changed. My view is that the NZ economy is no longer importing deflation from the rest of the world and therefore the recent jump up in tradable inflation is not a temporary one-off that will rapidly reverse. The two-year wholesale swap interest rate has decreased from 2.35% before the RBNZ statement last Thursday to 2.20% today. The conviction of the financial markets as to whether they think the RBNZ will be right or not with the lower inflation forecast will be witnessed through future movements in this two-year interest rate. A failure of this market interest rate to push lower and a return back to 2.35% over coming weeks would suggest that eventually the RBNZ will be forced to change their tune.

The foreign exchange markets will also tell us whether the RBNZ’s soft inflation outlook will prove to be accurate or not. With the US increasing their short-term interest rates twice more this year, the FX markets will push the NZD/USD rate below 0.6800 if they really believe the RBNZ will be right and the first OCR adjustment in New Zealand is not until 2019. A recovery in the NZD to above 0.6900 and 0.7000 over coming week/months will evidence a FX market verdict that the RBNZ will be forced at some stage later this year to change their inflation forecast, thus bringing forward the timing of the first OCR adjustment.

Potentially confusing the picture on monetary policy settings is the continuing increases in bank funding costs (from the Aussie banks in particular) and the passing through of these additional costs into lending margins to household, commercial and corporate borrowers. If borrowers in the economy are already experiencing increased interest costs from this source there is less pressure on the RBNZ to be pushing the OCR up to control inflation in the medium term.

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