Unusual Bank speech this week to direct markets
On Tuesday, Reserve Bank Chief Economist Paul Conway will deliver a speech on how the global economy has changed since the Covid pandemic, and the role of more frequent and accurate data to inform monetary policy decisions. Unusually, though, the speech will include “brief comments on domestic data developments” since the Bank’s last Monetary Policy Statement in November.
The inclusion of these comments is a surprise, because typically when the Bank makes a speech it emphasises the fact that it is not providing any new information on its current thinking about the economy or monetary settings. So hearing from a member of the Monetary Policy Committee comment on recent data outside of a scheduled Monetary Policy Review is essential viewing. Essential because this webinar is a chance for the Bank to shift the tone on where to next for interest rates – not with a concrete forecast of what’s next, but to lay the groundwork for a shift after a two-month hiatus and direct the market.
What might we hear? One option could see the Bank highlight that it believes market expectations have gone astray over the last couple of months and wants to pull them back towards the Bank’s line of thinking of “higher for longer”. Alternatively, the Bank itself might have changed its assessment of the economy, and it wants to give markets a heads-up before the next formal monetary policy review at the end of February that interest rate cuts are now more likely than the rate increase predicted in its November forecasts.
Financial markets have certainly been betting heavily in the direction of cuts over the last few months. Futures pricing shows that markets are now anticipating five cuts to the official cash rate by March 2025, in contrast to the thinking in October last year, when just one cut was priced in by the market in the next 18 months.
This shift in thinking is clearly demonstrated by movements in swap rates, which have dropped by as much as 130 basis points over the last 3-4 months. These swap rates are a key factor in the pricing of retail mortgage rates – even if fixed mortgage rates have so far only declined marginally since November.
Financial markets don’t always get it right
Experience over the last 18 months tells us that financial markets sometimes get overexcited about individual pieces of data. For example, a weaker-than-expected US inflation result in July 2022 led to premature hopes that inflation had been conquered, driving mortgage rates in New Zealand lower. However, the drop was quickly reversed the following month when US inflation came in stronger than expected. Sentiment was similarly dovish about the end of the tightening cycle in early 2023, only for a “higher for longer” narrative around interest rates to reappear, pushing fixed mortgage rates towards new decade-long highs later in the year.
So what’s different this time? Firstly, the decline in longer-term wholesale interest rates has been sustained for more than a month. Clear trends have developed in international data of moderating inflation and, in some cases, lacklustre growth results that point towards the next interest rate movements being down rather than up.
Most importantly for New Zealand, the change in sentiment has not been premised on lazy thinking such as “New Zealand was first to lift rates, so it will also be first to cut them”. Since October, the trio of major data releases covering inflation, the labour market, and GDP have all been at the weaker end of expectations. It’s taken a while for the data to paint a consistent picture, but there are now consistent indications across several data sets that the Reserve Bank’s tightening work is having the desired effect.
But the Bank has been struggling to keep up
We’re left with the dilemma that the mounting market expectation of interest rate cuts sharply contrasts to the tone of last November’s Monetary Policy Statement. The Bank’s hawkishness in that statement surprised analysts, as it focused on the inflationary risks posed by record-high net migration and its possible demand effects across the retail sector and housing market.
Before discarding the Reserve Bank’s viewpoint and running with the market’s expectations of interest rate cuts, it’s important to note that the implied speed of the market’s rate cuts looks overblown. The Reserve Bank will still be uncomfortable about non-tradable inflation sitting at 5.9%pa, with further evidence needed that these domestic price pressures will keep moderating back towards normal.
But the reality is that the Bank’s messaging throughout the last two years has often seemed to be about 3-6 months behind what the market is looking at. The start of interest rate rises and removal of other monetary stimulus took longer than it should have in 2021, with the Bank clinging to the view that inflation was only temporary and needed a limited response well into 2022. It wasn’t until the end of 2022 that the Bank implemented its largest single increase, of 75 basis points, despite calls for a bigger move in the middle of that year. Last November’s statement appears to be erring in the opposite direction – picking up on a theme of inflation risks around immigration that were more worrying in mid-2023, when there had been little sign that the increased number of people was actually boosting capacity in the labour market.
Right now, the Reserve Bank’s delayed reactions are exacerbated by the extended gap between monetary policy reviews over the New Year period. Perhaps in 2016, when the Bank gave itself an extended summer holiday and scaled back from eight to seven meetings a year, it was counting on the fact that it had only changed interest rates at the January review twice in the previous 16 years. But three months is a long time to hope that nothing significantly affects the economic outlook. It might be appropriate for the Bank to consider reverting to eight reviews per year, even if the January review usually just reassures markets that things are unfolding as had been anticipated prior to Christmas.