The OCR review: what could happen

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Reserve Bank Governor Alan Bollard will tomorrow morning reveal whether the Official Cash Rate will be changed. OMFinancial's head of financial markets Kevin O'Sullivan ponders what impact his decision might have.

Reserve Bank Governor Alan Bollard 
File photo
Reserve Bank Governor Alan Bollard File photo

This week's upcoming Reserve Bank monetary policy statement has generated more debate and discussion around trading desks both here and overseas than any in recent memory.

While the banks and other major institutions have almost unanimously predicted a cut in the official cash rate (and lowered their own rates in anticipation), it is important to remember this reflects the view of a very small percentage of people active in the market.

The majority either have not or can not take a position, and their views on what the Reserve Bank will do - and what it should do - cover a broad spectrum of opinion indeed.

So, what do those at the coal face think should happen, what do they think will happen, and what does it mean? Here are four possible scenarios.

Leave the Rate Alone

According to the Reserve Bank Act, the Bank's primary function involves "achieving and maintaining stability in the general level of prices."

According to the current Policy Targets Agreement, price stability is defined as an annual rise in the Consumer Price Index (CPI) over the medium term of between one and three percent.

With the CPI for the three months to December 2010 up four per cent, commodity prices continuing to climb, and European Central Bank president Jean-Claude Trichet foreshadowing higher ECB interest rates as early as next month, the case for a cut in the OCR looks less certain.

While the market suggests there is no chance of no change, and John Key's pro rate cut comments will have added political pressure to Governor Alan Bollard's list of considerations, a look back at recent history shows that Bollard is very much his own man.

In January 2010, the market was hell bent on pricing in rate hikes, but Bollard held his ground. The ensuing brutal rally in the futures markets hit traders squarely in the bottom line, and sent the market a clear message that Bollard would not be bullied.

A 100bp cut

In financial terms, the likely effect on the economy of the Christchurch earthquakes is comparable to that of 9/11 in the US prior to the earthquake, we had already experienced one quarter of falling GDP and another was expected to follow. Standard & Poor's' "revision" of New Zealand's foreign currency outlook last November and an unemployment rate that was already heading north (and which will be boosted by the tragic events in Christchurch) add weight to the theory that rate cuts are needed to stimulate the sagging economy.

In the words of one ex-pat trader: "This is a get out of jail free card for Bollard: play the quake card to not only remove the recent tightening but further stimulate the economy."

Having said that, a 100bp cut would be very aggressive, and put the OCR well below what Bollard has previously described as "emergency levels".

A 25bp cut

Tipped by at least one of the major banks, but at very long odds amongst dealers.

The actual impact of a 25bp cut would be...... well, no impact, and Bollard could be seen as a weak Governor who didn't want to cut but bent to Government pressure.

A 50bp cut

A 62 per cent chance, according to the market, and the most commonly expected outcome, but it raises a few questions of its own.

Will the currency go into freefall?

Unlikely. Whilst we may get a sharp sell off on the release, this will be a short term effect. We have to remember that the USD has been in a downward trend for a long time now, and even with a 50bp cut the yield on the NZD will still be 2.25 per cent higher than that on the USD.

Realistically, we are likely to see a greater effect on the NZD against other cross rates such as the AUD, EUR and GBP than the USD.

Will we be better off?

Presuming the banks pass on the full 50bp rate cut, a person with a $300,000 mortgage currently paying 6.5 percent floating, would be $28.85 better off per week. Sounds good, but what about the strings attached?

Firstly, the strings which are outside the Government's control; the price of oil for example. Another 50 cents a litre would soon take care of the extra $28 dollars per week. Secondly, the strings being pulled by Key and Co, specifically the budget. Expect a much tighter budget to be announced with a lot of resources going to Christchurch.

How does this help Christchurch?

We need Christchurch back to its former power: it's a vital cog in our economy. However, the city's problems need fiscal solutions, not monetary ones. There is no way around it, Government election promises are going to have to be broken to pour fiscal help into Christchurch, and New Zealanders generally will foot the bill for that response.

In that sense, a rate cut could be seen as a "softening up" for another "Mother of All Budgets". We can only hope the unavoidable budget cuts do not become a political football: we have witnessed amazing acts of generosity and compassion since the latest earthquake, and people, including politicians, should see the upcoming costs as another way to give to our family in Christchurch, many of whom have lost a lot more than money.

Will the banks pass on the full benefit?

Short answer here is, you would hope so. Already the banks have offered very generous support to Christchurch and I think they will be very aware that if they don't pass on the full benefit their reputations could well take a hit that, in the current competitive environment, would take some time to overcome. So expect any cuts to be passed on.

What comes next?

So how will our financial landscape look after Thursday? A lot will depend on not only what Dr Bollard delivers but how he delivers it. I expect the fast approaching inflation pressures will make any cut short-lived.

Personally, I will be looking to hedge against future rate hikes, as I believe when our rates start heading north they will do so very quickly, and if I was an exporter to Australia I would look to take full advantage of the current exchange rate.

Kevin O'Sullivan is Head of Financial Markets at broking house OMFinancial

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