Picks for the December RBNZ meeting

I’m going with a 75 basis point cut on December 4. Now no-one might agree with this, iPredicit certainly doesn’t (putting the probability at 3% when I looked), but there are reasons:

Update: I brought some 75 shares in iPredict after posting this post – because agnitio told me to.

  1. Petrol price collapse (which might be seen as inflationary),
  2. Mortgage rate collapse,
  3. Wholesale cost of credit is falling.

In fact, I would go for a 50 if it wasn’t for the fact that 2 year ahead inflation expectations tumbled to 2.7% in the December quarter! Let me sort of sketch out why.

When the RBNZ is setting interest rates, we need to think about where their “neutral rate” is, this is the rate where monetary policy is neither aiding or hindering growth . A rough version of the neutral rate could be: Neutral = pop growth + time preference (which is a function of expected per capita growth) + inflation.

As population growth is kicking around 1%, natural per capital growth slapping around 2%, and underlying underlying inflation is at 3.5%, the neutral nominal interest rate is 6.5% – hey that is where we are now! Of course there is currently a risk premium which is knocking up market interest rates – implying that neutral is closer to 6.0%.

Now I might be overplaying inflation – but I am probably underplaying “time preference” anyways, so things should all equal out 😉

With fundamental inflation pressures still strong (at least according to the LCI) they may not want to go too far under neutral. A 75 basis point cut (which would take the OCR to 5.75%) would put us just under neutral, but would give the Bank scope to keep an eye on how data unfolds before loosening further. Furthermore, the Bank can commit to cutting further in the future – say to 5%, thereby loosening current monetary policy without unnecessarily throwing around the official cash rate given uncertainty about future outcomes.

The market expects 125 points of cuts. Economists expect 100 (by median) with a few picking 150. Ipredicit seems to be poking towards “above 100” (the other contract, the 100 contract, and the 50 contract) I’m sitting on 75.

I can see these higher outcomes occurring (specifically 100 – Update given that market expectations are for 125 and wage growth expectations are falling), but given my view of neutral and the existence of elevated “uncertainty” I just can’t sell a bigger cut than 75 to myself. Sure things are bad; commodity prices are falling, world activity is declining, and we have been sitting in a recession for nine months – but a 75 basis point cut in the face of loosening wholesale markets is still one hell of a softening in monetary policy!

What do you guys think?

Update again:  It is a few days after I have risen this, and now economists are picking 150bp.  Did anything unexpected actually happen?

  • You have officially been tagged by MandM 🙂

  • the big question is, are you putting your money where your mouth is? 🙂

  • “You have officially been tagged by MandM”

    Super – I wonder if we have to do seven facts each – I suppose I should have an email conversation with the other main authors 🙂

    “the big question is, are you putting your money where your mouth is? ”

    No – but I guess I should.

    Tell you the truth, the vicious drop in expected hourly wage growth has now made a 100 basis point cut pretty likely – I’m still sticking to 75 as my main pick but …

    http://tvhe.wordpress.com/2008/11/26/inflation-expectations-begin-to-moderate/

    Yea, I’ll put some money on 75 – I better make an account today then 😛

  • Ok, I’ve put some money on it 🙂

  • goonix

    I’ve taken a long-shot punt on it too Matt. I think 100 point cut is underpriced too, although I think I’ll wait until the day to make my money.

  • “I’ve taken a long-shot punt on it too Matt. I think 100 point cut is underpriced too, although I think I’ll wait until the day to make my money.”

    100 is viciously underpriced, and even though I think the 75 is the right move – there is a risk that the Bank won’t want to surprise the market that much.

    In my portfolio I’m going to try to build up 75’s before the day, but keep a small stock of 50’s and 100’s to limit any loss. As a result, I’m primarily betting against a cut of over 100.

    Note: All that has changed since October 23 is lower oil prices, a lower exchange rate, and the govt promising a larger fiscal stimulus. This is what the RBNZ said would limit any movement in the OCR in December:

    “The reduction in domestic spending will be partly offset by the depreciation of the New Zealand dollar over the past few months, falling oil prices and the recent loosening of fiscal policy”

    Hmmmm.

  • Also, could you guys stop driving up the price – I haven’t bought most of my stocks yet!!!

  • goonix

    LOL!

  • Hopefully some people will come on and bet against what I’m saying – then I can buy at a cheaper price 🙂

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  • I think Bollard would like to go by 0.75%, but the world still is in a race to zero. Broad expectation is for 1% and thats what he will go with, if only to meet expectations.

    The RISK is that he cuts less than expected and the NZD rallies on the higher than expected interest rate differentials.

  • Hi Kiwi Trader,

    Market pricing actually suggests a 125 basis point cut at the moment. This is the kicker – as long as market pricing is up there it would be hard for the back to cut as low as 75bp.

    Watch the Aussie rate decision next week as a lead indicator of what our Bank will do – if they go less than 75bp then 75 looks like a good possibility – if they go 75 then 100 is really on.

    I think the Bank will be happy to go below market expectations a little bit – just to hit them back to reality. The fact is that oil prices have collapsed, domestic institutions are still strong, and some export prices are not falling – they will be weary of over-reacting, and will be keeping in mind where neutral lies.

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  • DG

    Don’t forget that the RBA have already eased by 75bps since the RBNZ last met…if they do another 75bps on Tuesday (and 100bps is priced) then that makes 150bps.

  • “Don’t forget that the RBA have already eased by 75bps since the RBNZ last met…if they do another 75bps on Tuesday (and 100bps is priced) then that makes 150bps.”

    We started cutting before them – and we have cut more quickly than they have. Since they cut monthly they have knocked off 25bp more than us, if they knock off 75 that takes the gap to 100.

    Now, that would make the case for 100 pretty strong I agree. However, with hard commodity prices falling more quickly than soft commodities, and with New Zealand having “purged” some of its imbalances earlier in the year already this wouldn’t put me off calling 75.

    If they do cut 100 (as the market is picking), then we are facing a different kettle of fish – once we see how they cut and why we will have a clearer idea of what New Zealand will do. As a result, lets keep a close eye on Tuesday 😉

  • Latest poll

    Latest poll out this morning shows 8 of 15 economists now picking 150bps, market pricing is up over 130bps this morning after the October building consents report was the worst since 1980.

  • Yep. The poor National Bank survey didn’t help matter either.

    But …

    We’ve known that the consent numbers would be this low for a couple of weeks now. The National Bank survey was bad – but not as bad as some people were expecting.

    I realise that my pick of a 75bp cut is outside of the consensus, but I think other people are underestimating the size of the income boost that has already been provided by lower oil prices – they have done some of the loosening for the bank already!

    Furthermore, the government wants to throw in 7bn to the economy – this reduces the required cut in interest rates.

    Economists have moved from a consensus of 50bps of cuts to 150bps of cuts on virtually no new negative information (as expectations for consents, retail sales, and business confidence will have been consistent with the outcome) – that is what I find suspicious here.

  • Latest poll

    IMHO I think what you are missing is developments offshore – two months ago the consensus was picking trading partner growth of 2.6%, now it is 1.3% and falling…some are saying it could be zero or less. And whilst low petrol prices are good for the consumer, don’t forget that all commodity prices are falling…and we export far more commodities than we import. The terms of trade will be down sharply over the next 12 months, that is never good. Finally, the $7bn stimulus is – as far as I can tell – mostly a relabelling of spending already announced. It’s important, not a good reason to leave interest rates at neutral levels. I guess we will see on Thursday. 1 of 15 economists in the poll does share your view (private sector forecaster, not a bank).

  • “two months ago the consensus was picking trading partner growth of 2.6%, now it is 1.3% and falling…some are saying it could be zero or less”

    Indeed – of course this only matters insofar at it influences our terms of trade, as you go on to mention.

    Our terms of trade was at a historic high, as lower dairy prices and some pressure on meat and log prices feeds through it will fall further – even given the drop in oil prices. I agree, and as a result I agree that we need to move into easing territory.

    However, a 75 basis point cut does take us into easing territory – especially if lending conditions continue to improve.

    Looking at the previous RBNZ forecast we can see that they were already forecasting a sharp drop in our terms of trade in their initial forecasts – since then we have discovered that New Zealand has becoming significantly more credit constrained, another reason why the bank will want to cut rates.

    However, since October 23 the outlook for the credit market hasn’t worsened – I can’t see that as a justification for a 150 basis point cut. Furthermore, if the RBNZ has a WORSE terms of trade story than they did in their September forecasts I probably wouldn’t believe it.

    I think that other analysts are underplaying the importance of loosening fiscal policy and the drop in oil prices on the Reserve Banks rate decision – after all they cut rates in July, against economist expectations, as a result of rising fuel costs.

    Note: I work for the one organisation that is picking 75 🙂

  • DG

    IMHO there i no way that 5.75% can be regarded as stimulatory in the credit environment that we find ourselves in today. I hope you are right but I think that the asset price deflation we are seeing overseas – and in NZ – has further to run and will be more costly than your comments suggest. For example, looked at either relative to incomes or rental returns NZ housing is still horrendously overpriced relative to history and this will not be sustained in the more normal credit environment we will face in coming years (the environment over the past few years was not normal). That is going to weigh heavily on the economy. I agree that the credit environment has not worsened since October. What has changed is peoples understanding of the implications of everything that has happened since July 2007. Take a look at the Japanese economic reports that came out this morning. Absolutely awful. Must admit, we are living in an interesting world where we are debating whether the rate cut will be 75bps or 150bps! You would have been placed in a white coat if you started that debate earlier in the year.

  • “IMHO there i no way that 5.75% can be regarded as stimulatory in the credit environment that we find ourselves in today”

    Fair call. However, how stimulatory do we want monetary policy to be if we expect oil prices to remain low and fiscal policy to become more expansionary?

    Note, I wouldn’t expect 5.75 to be the end of the cycle – the Bank would signal a much lower rate at some point in 2009. This is how the Bank can influence future rates now, even without committing to an immediate cut in banks opportunity cost of lending.

    However, why would they risk cutting 150 basis points now when there is the chance that the significant decline in oil prices could reignite domestic spending activity. Uncertainty creates risks on both sides – and we face an uncertain environment at the moment.

    “I hope you are right but I think that the asset price deflation we are seeing overseas – and in NZ – has further to run and will be more costly than your comments suggest”

    Asset price deflation costly, huh? As long as there are buyers and sellers it doesn’t matter – the only issue appears when asset price deflation prevents lending that is in everyones interest. These sorts of credit rationing events do call for expansionary policy – but maybe not to the degree that other commentators are calling for.

    For the Bank it is all about the demand curve – lower petrol prices increase demand, expansionary fiscal policy increases demand. Inflation still exists and the labour market is still tight. There is enough concern to prevent a 150bp cut methinks.

    “Must admit, we are living in an interesting world where we are debating whether the rate cut will be 75bps or 150bps!”

    Indeed – it is crazy.

  • DG

    I think the real inflation risk is actually a few years away when central banks with bloated balance sheets and govts with high debt levels will have every incentive to tolerate higher inflation. But right now inflation is about to be zapped by mass unemployment and the collapse in commodity prices. Hence why yield curves are flattening out to 10-years but steepening from 10-years out. On the labour mkt, how many job losses do you expect to see in construction over the next year – I’d say 20,000 was conservative – about one-third of the increase over the past 7 years – and employment in the sector rose almost 50% over that period. It is not going to be pretty in high labour intensity areas like retail and tourism either. I fear our labour mkt will be a load less tight in 12 months time. At least we have made a reasonable start in the cricket…

  • “On the labour mkt, how many job losses do you expect to see in construction over the next year – I’d say 20,000 was conservative – about one-third of the increase over the past 7 years – and employment in the sector rose almost 50% over that period. It is not going to be pretty in high labour intensity areas like retail and tourism either. I fear our labour mkt will be a load less tight in 12 months time”

    Indeed – our labour market will weaken, that is without doubt. But it still needs to weaken a fair way before our labour market is in neutral – let alone weak.

    I feel that the labour market will weaken sufficiently now, and I can see the OCR falling further as a result – but stimulation from fiscal policy and a collapse in oil prices the OCR may not need to fall as much now.

    I just can’t get past the fact that I am being hawkish with a 75bp cut!

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