OCR on hold but maybe not for long

The Reserve Bank Monetary Policy Committee announcement last week was one of the most highly anticipated for many years. The recent series of readings on the New Zealand economy have all been pointing towards an economy that was building up a good head of steam. Expansion, rising prices and low unemployment, compounded by a general gorging on cheap debt that created an explosion in house prices.

This chart from the Reserve Bank Monetary Policy Statement (MPS) pack issued last week neatly sums up the situation. In May, a mere three months ago, the RBNZ was comfortably forecasting inflation to continue to be a very obedient charge of theirs and sit nicely inside the targeted, and shaded, 1-3% range. Suddenly it is a very different forecast, with inflation expected to punch higher and out of the target range in the near term. The Reserve Bank had halted the additional government bond purchase programme in July, but an official Overnight Cash Rate (OCR) of 0.25% still represents an incredibly easy and stimulative monetary policy setting. One that is highly inappropriate for a central bank that is forecasting inflation to rise rapidly in the near term.

Hence the market expectation that we had finally reached the point that the Reserve Bank had to start tapping the brakes by increasing the OCR. The market expected at least an increase of 0.25% with some possibility of a 0.5% increase. As the chart below shows, this was going to be the first rise of any sort for seven years, but more significantly the first of a likely series of rises since 2004 when the OCR went from 5% up to a high of 8.25%. A potential paradigm shift for New Zealand’s interest rates.

Chart showing the past 22 years of New Zealand’s Official Overnight Cash Rate

That was until, almost exactly 24 hours before the Reserve Bank was due to announce its OCR decision, word got out of a Covid-19 case in the community without any clear connection to an MIQ facility, or any other potential border facility. It was a given that this case would be a Delta variant. The investment markets can be whipped quick at times, and this was one of those times. Within mere minutes of the news hitting the wires the New Zealand dollar was down 0.5 cents against the Australian dollar

Chart showing five and a half hours of the NZ Dollar vs AU Dollar exchange rate

The chart above shows that at 2:30pm last Tuesday afternoon the New Zealand dollar could be exchanged for nearly 96 Australian cents, and minutes later that reduced to 95.5 Australian cents. The New Zealand dollar continued to weaken through the day until at 6.10pm in the evening when a level 4 lockdown of the entire country was announced by the Prime Minister. By that point the New Zealand dollar had dropped another 0.5 cents against the Australian dollar. The market instantly realised that the Reserve Bank would no longer be making any changes to the OCR in light of the uncertainty created by the sudden Level 4 lockdown and associated community outbreak of the virus.

This sudden lack of OCR hike, whether it was going to be 0.25% or 0.50%, undermined the investment case for a strengthening New Zealand dollar on the back of a positive and increasing interest rate differential versus all the other developed countries across the globe. Hence the near instantaneous selling of the New Zealand dollar that kicked in last Tuesday afternoon and continued through the day until the eventual confirmation of a Level 4 lockdown that evening.

So what next for the Reserve Bank and the OCR? The answer is that it mainly depends on the extent and duration of the current lockdowns. The situation unfolded very rapidly over the course of last week and doubtless has continued since this article was written. But the reality is that the economic readings that led the Reserve Bank to start a tightening cycle are unlikely to ease any time soon. Last year, pent up demand led to a post lockdown rebound that was sharp and strong. There is no reason to not expect the same again when we come down the lockdown levels and the Reserve Bank will be acutely aware of that. The unknown is when will we come down the lockdown levels, but the worst-case scenarios have improved since the week progressed.

If the snap Level 4 lockdown does work and restrictions come down over September and economic activity rebounds, the Reserve Bank is in a real bind. It was denied the OCR increase that it would definitely have made last week and would now face the prospect of being well and truly “behind the curve” of interest rate rises required to control rising inflation. That could lead to the rare as rocking horse poo, unscheduled, surprise OCR rise, with the Reserve Bank unprepared to wait for the scheduled November MPS. If that were to happen, watch out, you may see the exact opposite of the abrupt fall in the New Zealand dollar that occurred last Tuesday afternoon as New Zealand would become the first OECD country in the world to start a cycle of interest rate hikes.