MNI INTERVIEW: Early OCR Cut On Rising Bank Costs - Ex-RBNZ

The cost of funding for New Zealand’s banks will increase as a key Reserve Bank of New Zealand support facility winds down, increasing interest and deposit rates, slowing the economy and potentially prompting an earlier-than-forecasted cut to the Official Cash Rate, John McDermott, executive director at Motu Economic and Public Policy Research, told MNI.

The RBNZ implemented the Funding for Lending programme in 2020 during the pandemic alongside the Large Scale Asset Purchase programme. The facility, which ceased in 2022, allowed eligible banks to borrow at three-year maturities directly from the central bank at the OCR. The programme held NZD19 billion at April 2023, or 23% of the RBNZ’s total outstanding liquidity management operations, while the LSAP stood at NZD43.3 billion.

McDermott, former assistant governor at the RBNZ until 2019, noted banks will look for alternative sources of funding as the facility rolls off, either encouraging deposits or issuing debt in offshore wholesale markets. “Either path will see the cost of funds for banks increasing,” he explained. “Even if the facility accounted for 5-10% of new lending back in 2020, that's enough to make a big difference for interest-rate pricing.”

He added banks will attempt to preserve net-interest margins and pass costs onto customers, which will pressure lending rates. “The first thing the RBNZ will watch is inflation heading towards the [1-3%] target by the end of the year, and if the cost of funds for the banks is increasing, maybe [the Reserve] might have to relieve that pressure.”

RBNZ Chief Economist Paul Conway told MNI this week the Reserve would likely hold the OCR at its current 5.5% peak until at least mid-2024, barring unforeseen challenges (See MNI INTERVIEW: Rates At Peak, No Cuts Soon-RBNZ's Conway). But Conway’s position runs counter to the market, which has priced in a February cut.

McDermott said the lending programme’s nature had added automatic tightening into the system that would require an offset at some point. “We can worry about net migration, but that's quite uncertain,” he argued. “We then look at future inflationary pressures by the state of the economy and people have different judgements, but there is a lot of fracture points showing up. Those fracture points could emerge just at the time when this Funding for Lending programme adds tightening into the system."

WHERE TO?

McDermott said the RBNZ could cut rates earlier than it currently forecasts. Pointing to rates higher for longer increased the effectiveness of tight monetary policy, he noted, though the Bank would avoid talk of cuts until inflation had declined significantly.

“[The RBNZ] also needs to regain credibility – it has a plan to fix inflation and it wants to see inflation come down. The Reserve might become uncomfortable if the market started pricing in cuts too early, because the previous actions will have less force and less effect on inflation.”

TIGHT LABOUR MARKET

McDermott warned against watching labour-market moves as a leading indicator, noting the metric would be one of the last to shift due to its tight level. “There's an expectation that we've slowed the labour market which is incredibly tight,” he commented. “But I also think [the RBNZ] acknowledges that's the last thing we'll adjust for.”

The latest Monetary Policy Statement forecasted unemployment to reach 4.9% in 2024 and 5.4% in 2025 before reducing to 5.2% in 2026, a stark change from the 3.4% recorded over the March quarter.

“We're seeing goods prices fall and inflation expectations starting to adjust. The last part of the business cycle to recalibrate is typically the labour market. It’s so incredibly tight that this might take longer than otherwise would be the case. The unemployment rate may not actually get as high as the RBNZ is forecasting.”