RBNZ: glass half full? - Westpac

Analysts at Westpac explained that last week’s Monetary Policy Statement was very much in line with expectations.

Key Quotes:

"The Reserve Bank left the OCR unchanged at 1.75% and issued the same forward guidance it has used all year. Essentially, the OCR is on hold, and the RBNZ expects that it will remain on hold until 2019, although there are large uncertainties on both sides.

While the overall tone of the MPS was both neutral and much the same as previous missives, there was a lot going on beneath the surface. The RBNZ acknowledged that the housing market and construction activity were weaker than previously anticipated, and downgraded its forecasts in both areas. This downgrade was overdue – we had complained that the RBNZ was too optimistic on construction and house prices in its August MPS. But offsetting these downside developments, the RBNZ acknowledged that the lower exchange rate will support inflation, and that the Government’s fiscal plans would stimulate the economy.

The standout for us was the RBNZ’s extraordinary optimism about future GDP growth. The RBNZ estimated that the economy grew 0.7% in the September quarter this year, whereas our estimate is 0.4%. The RBNZ went on to forecast that GDP growth will be 0.9% in December 2017, rising to 1.2% in March 2018. That would make March the strongest quarter of GDP growth in four years. These are heroic forecasts, to say the least. In recent times we have seen business confidence dropping away, the housing market slow and construction activity stagnate. With the uncertainty associated with a change of Government lying ahead of us and population growth slowing sharply, we find it highly unlikely that the economy will reach these heights. Our own forecast for GDP growth in the March 2018 quarter is 0.5%.

The RBNZ was also very optimistic on GDP growth over a longer timeframe, based on the idea that the new Government’s policies will tend to boost the economy. In turn, this will apply upward pressure to inflation, necessitating a higher OCR than otherwise. The RBNZ looked at four areas of proposed Government policy: extra spending on education and health, the Kiwibuild residential building programme, hikes to the minimum wage, and plans to reduce incoming migration to New Zealand. On balance it judged these to be a positive stimulus to inflation, necessitating an OCR perhaps 50 basis points higher than otherwise.

We broadly agree with the RBNZ on these areas, although we would quibble with their assumptions around Kiwibuild – we think it will mostly displace private sector activity and will therefore have little impact on overall construction activity.

But we suspect that the RBNZ has not allowed enough for the Government’s plans around the property market. The Government is planning to restrict foreign purchases of residential property and to change the tax treatment of property investors. Furthermore, it plans to convene a tax working group that might recommend a capital gains tax or similar. We expect that these actual and prospective tax changes will cause the housing market to weaken noticeably next year.

Furthermore, the RBNZ is assuming that any weakness in the housing market will have little impact on consumer spending. Here we disagree strongly, and recent evidence is on our side. Last Friday’s electronic card transactions data registered yet another very small rise in spending, despite booming population growth. Spending on durables has been particularly weak, falling 2% over the past three months. This looks to us like a classic response to a weak housing market, which could intensify next year if house prices remain soft.

The other area that the RBNZ may be disappointed in is export conditions. We expect New Zealand’s export commodity prices to fall next year, due to an expected slowdown in China’s economy. Indeed, dairy auction prices are already falling – this week’s auction registered a 3.5% decline in the overall dairy price index, with whole milk powder down 5.5%. This is the latest in a string of auction price declines, which has cumulatively been enough for us to downgrade our forecast farmgate milk price for the 2017/18 season to $6.20/kg (previously $6.50). Fonterra’s $6.75/kg forecast is now looking well out of market. We have also published for the first time our milk price forecast for the 2018/19 season. We expect the payout to increase to $6.50/kg, on the basis of a revival in the Chinese economy from late 2018 and supported by a lower average exchange rate over the season.

Putting all of this together, we expect that the RBNZ will be surprised by slow GDP growth, weak house prices and falling export commodity prices over 2018. If we are correct, the RBNZ will become more dovish.

There could be a couple of other knock-on effects to consider. First of all, the exchange rate would fall even further in these conditions, providing some offset from an inflation point of view. Second, a weak housing market could prompt the RBNZ to loosen macro-prudential policy. The RBNZ Governor this week said that the criteria under which the LVR mortgage lending restrictions may be loosened will be outlined at the Financial Stability Report on 29 November. Any loosening would likely be incremental, but still might have a positive influence on the housing market."