Reserve Bank holds at 2.25%, but watches vigilantly

The key numbers...

The Reserve Bank kept the official cash rate (OCR) unchanged at 2.25% today, as expected. However, the tone of the statement was arguably more hawkish than the Governor’s speech two weeks ago, with the Bank focusing on the upside risks to inflation from more generalised price pressures resulting from the Middle East conflict.

Regarding the inflation risks, the Bank stated that the “Committee is vigilant to any generalised inflationary pressure and stands ready to act to return inflation to its medium-term target.” It also said that it “requires core inflation and wage growth to remain contained and medium- and long-term inflation expectations to remain around 2 percent… [or] decisive and timely increases in the OCR would be required.”

With the Middle East conflict almost six weeks old, the Bank understandably remains unsure about the relative effects of higher fuel costs and weaker demand conditions on inflation outcomes. Some of the Committee emphasised the possible need for an earlier monetary policy response to limit the need for more interest rate rises later, while other members saw downside risks to growth and the potential for a rate rise to add unnecessary volatility to the economic outlook, particularly if the conflict was resolved in the near term.

Today’s statement did not include a full economic forecast by the Bank. However, the Bank provided updated estimates for inflation in the March and June quarters, of 3.0% and 4.2%pa respectively.

...and our reaction

Although the Bank’s statement concluded with arguments for and against an interest rate rise, the statement gave a strong indication that the Bank is taking the inflationary risks of supply shocks more seriously than it did five years ago. The Bank recognises the downside risks to economic activity from the oil price shock, but it is less convinced that weaker growth will necessarily translate into more well-contained inflation.

One facet discussed by the Committee was the risk of higher inflation being “accentuated by current tight business margins given weak activity and substantial cost pressures, which could limit the degree to which some firms are able to absorb further cost pressures.” This view is more nuanced than previous communication by the Bank, which relied on the standard argument of current spare capacity in the economy being likely to limit the pass-through of higher fuel costs.

Absent from today’s statement was any discussion by the Committee about the potential need for interest rate cuts to support the economy in the face of weaker growth. We agree that further interest rate cuts would be inappropriate given that inflation expectations are somewhat elevated, and the starting point for inflation prior to the fuel crisis was over 3%pa.

Although we have interpreted today’s statement as relatively hawkish, it rightly provides no indication of when the Bank might start to raise interest rates. The Bank will be relying on a mix of survey data, qualitative feedback from businesses, and high-frequency partial data to try and judge whether it needs to start lifting interest rates earlier.

The next Monetary Policy Statement is on 27 May, which might be too soon for the Bank to make a firm judgment on whether inflationary pressures are becoming more pronounced than it is comfortable with. We currently expect the first interest rate rise to occur at the following review in July, and we have brought forward the timing of this increase as part of our updated economic forecasts that will be published on 17 April.

We also note the potential for events in Middle East to move rapidly and affect assumptions around the economic outlook. For example, today’s announcement of a ceasefire has resulted in a sharp drop in oil prices to below US$100/bbl. Even so, oil prices remain well above their pre-conflict levels. Furthermore, immediate fuel costs across Asia and New Zealand will stay elevated due to the “air bubble” in the supply chain, caused by the closure of the Strait of Hormuz over the last six weeks, which will need to be rectified before prices can normalise.