Steen Jakobsen
The Bank of Japan has abandoned quantitative easing and the European Central Bank may taper its bond-buying programme, so what is the role of central banks in 2017, asks Saxo Bank’s chief economist Steen Jakobsen.
Article / 17 October 2016 at 22:49 GMT

NZDUSD climbs on inflation data – now for a rate cut

Managing Director / Technical Research Limited
New Zealand
  • New Zealand's CPI numbers come in low but match expectations 
  • NZD is now close to RBNZ projections 
  • The central bank will let the economy expand above potential to generate inflation

By Max McKegg

The US dollar gave back some of its recent gains heading into the New York close today, giving NZDUSD a boost ahead of its big data test for the month: the September-quarter Consumer Price Index. Expectations were for a reading close to zero year-on-year, virtually locking in a rate cut by the Reserve Bank of New Zealand at its next meeting on November 10.

 The Kiwi now sits exactly where RBNZ Governor Graeme Wheeler wants it. Photo: iStock
In the event the number came in at 0.2% for the year ended 30 September, close enough to forecasts, but slightly better than some had feared. NZDUSD rallied from 0.7135 to 0.7185 before easing back, and money market pricing for a 25 basis point cut to the policy rate – taking it down to a record low of 1.75% – stayed around 85%, effectively a done deal. The positive move in the exchange rate reflects a view that the November 10 rate cut will be the last in this cycle.

Source: Westpac

As the chart above shows, the current subdued inflation rate is being caused by a decline in the price of tradeable goods, that is, those exposed to international competition. Global prices aren’t about to rise in a hurry so the best way to remedy the situation is via a lower exchange rate. The RBNZ has been advocating this for a long time and consistently forecasts it, as shown in this chart of the Trade Weighted Index. Just as consistently the market has ignored the central bank’s wishes but the recent fall in the Kiwi dollar will have made Governor Graeme Wheeler much happier as it now sits almost where he wants it. Cutting the policy rate again to 1.75% next month might just about do the trick.

Trade weighted index (click to enlarge)
 Source: Metastock, Reserve Bank of New Zealand

Last Friday, FOMC Chair Janet Yellen mused about the pros and cons of a monetary policy strategy that would allow the US economy to expand above its potential growth rate for a while in order to reverse some of the “supply side damage” caused by the global financial crisis. One of the cons would be the risk of a sudden boost to inflation.
She should be so lucky. The FOMC’s own projections suggest GDP will struggle to reach an annual growth rate of 2% anytime over the forecast horizon. That’s below most estimates of its potential (the growth rate if capital and labour resources are being fully utilised). In other words, the US will continue to have a negative output gap, as will most other advanced economies (see chart below). So Yellen’s musings about running a “high pressure economy” are of a theoretical nature only and won’t be put to the test anytime soon.
Not so in New Zealand where the output gap has closed in recent years as booming immigration and a steady rise in the labour force participation rate increase capacity and drive economic growth above 3% per annum with no sign of any slowdown.


Source: Reserve Bank of New Zealand
In days gone by a central bank would “take away the punchbowl” when they saw the output gap moving into positive territory, on the basis that an overheating economy would generate inflation as surely as night follows day. But the Reserve Bank of New Zealand won’t be doing that; if anything they will be topping the bowl up via at least one more rate cut. If the only way to generate inflation is to overheat the economy that’s fine by them and a temporary overshooting of the 2% target would be a small price to pay.
The Bank of Japan’s latest monetary policy revamp has exceeding the inflation target as a specific goal and last week Bank of England Governor Mark Carney suggested he too was prepared to “tolerate a bit of overshoot in inflation” in order to support economic growth. No doubt the European Central Bank would be in agreement. But none of these major economies is growing fast enough to generate old fashioned demand-pull inflation. New Zealand’s is. So the Bank of Japan, Bank of England, European Central Bank and the US Federal Reserve can sit back and watch the Reserve Bank of New Zealand put into practice what they can only dream about.
As the chart below shows, the RBNZ is expecting a substantial inflationary response from allowing the economy to run a little “hot”. A significant part will be the result of base effects – price decreases over the past year dropping out of the annual calculation – but the net result will be headline inflation moving back up to the bottom of the 1%-3% target range by year end, en-route to the mid-point early in 2018. Today’s numbers are consistent with that outcome. They are also consistent with a rate cut on November 10 being the last move by the RBNZ.


Source: Reserve Bank of New Zealand
For NZDUSD traders, attention now turns to the Global Dairy trade auction and the Consumer Price Index update out of the US, both due shortly after New York opens. Futures markets suggest higher milk prices at the auction due to reduced volumes on offer. That would give a boost to the Kiwi dollar.
Last month’s CPI numbers showed headline inflation crawling up to 1% year-on-year in the US but some analysts are predicting a jump to as high as 1.5% this time around due to base effects. Such talk must be music to the ears of the FOMC, but they’ll believe it when they see it. A strong number would all but lock in a December rate hike and the immediate effect would be a stronger US dollar and therefore a weaker NZDUSD.

– Edited by Susan McDonald

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.


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