Opinion: Flippity-flop—The RBNZ’s upcoming OCR review, and a case for changes to the way OCR decisions are made

Post by David Cunningham - Squirrel CEO

In a nutshell:

• Economists are (almost universally) predicting the Official Cash Rate will fall somewhere between 0.5% and 1% by the end of the year, with many calling for a cut in August 2024.
• Once they do start to come through, these cuts will flow through to lower mortgage rates relatively quickly, helping to lift NZ out of the forecasted “triple-dip” recession.
• In the scheme of things, the Reserve Bank’s (RBNZ) apparent flip-flopping in recent months in terms of the timing of interest rate cuts won’t change the course of history. It’s a near-term timing impact.
• Most importantly, inflation in NZ has now been tamed—though not without considerable cost to Kiwi businesses and consumers. The long-term benefits of stable prices will nevertheless prevail.
• In my view, there are two changes required to the way the Monetary Policy Committee (MPC) operates.
  • Remove the focus on consensus. In my experience shooting for consensus only encourages “group think”, and—at least in my view—that’s one of the main causes of the inconsistences in RBNZ messaging over the last few months.
  • Move to the MPC having a majority of independent members, rather than the current approach—where the majority are RBNZ staff.

It was a few months ago now, back in April, that I first called for the Reserve Bank (RBNZ) to start the process of gradually cutting interest rates.

My argument was that by continuing to hold the Official Cash Rate (OCR) at 5.5%, the RBNZ would effectively still be tightening monetary conditions—as those last remaining borrowers rolled off lower fixed-rate mortgages—and that with the economy showing clear signs of sliding back into recession, this was unnecessary.

At the time, it was a pretty lonely position to take, with the general consensus across the market being that falls wouldn’t come until sometime in mid-2025.

Then, in May, I talked about the fact that it was our inflation outcomes for the June and September 2024 quarters which would be the deciding factor in when the RBNZ started to drop interest rates.

The RBNZ’s forecast was that quarterly inflation would come in at 0.6% for the June quarter, and 1.3% for the September quarter.

As it turned out, June quarter CPI came in at 0.4%—0.2% lower than the RBNZ had predicted. We won’t know the September quarter CPI until mid-October, but my expectation is that it will be materially lower than that RBNZ forecast (1.3%) meaning annual inflation could easily fall to 2.5% or less. 

The below graph shows New Zealand’s actual quarterly CPI outcomes, coupled with the RBNZ’s forecasts through until the end of 2025 (from its May 2024 Monetary Policy Statement).

The May 2024 RBNZ forecast of no OCR cuts until mid- to late-2025 went out the door in its July OCR review. So is there a chance it will ‘play ball’ and deliver a cut this week?

In that May article, I argued that—even then—we were already seeing plenty of signs to suggest that CPI inflation would come in lower than the RBNZ’s forecast, including indicators that GDP growth was likely to be anaemic over the course of 2024.

A few months on, and it turns out most bank economists are now picking negative GDP growth in the June 2024 quarter—with some calling it a “triple dip recession”.

That’s led to a huge turnaround in terms of the market’s prediction for when interest rates might start to fall. Most bank economists are now picking OCR cuts of between 0.5% and 1.0% before Christmas, with three of the five major banks calling for that process to start on 14^th August. 

Personally, I think the RBNZ is highly likely to push through its first OCR cut this week.

And that it will also take this MPS as an opportunity to update its inflation forecasts, and confirm that inflation will be well below 3% by September 2024, and headed for 2% in 2025 – bang on the mid-point of its 1%-3% target band.

It would be a huge turnaround from the RBNZ, but it wouldn’t be the first time it’s flip-flopped on us

Back in May 2024, after a year of “no change” to the OCR, it came out with an unexpectedly hawkish message—one which took even the markets by surprise—with a new forecast which included the possibility of further hikes, and with no cut in the OCR until late 2025.

Then in July 2024, it backtracked on that with what economists called a “dovish hold”, signalling that in light of weaker-than-expected leading economic indicators, its inflation forecasts, and therefore OCR forecasts, would be lower than previously signalled.

Unless the RBNZ is seeing something the rest of us aren’t, I expect its August 2024 Monetary Policy Statement (MPS) will show inflation over their three-year forecast horizon of between 2.0% and 2.5%.

The net result of that, in my view, will be that delivers its first OCR cut in August 2024, of either 0.25% or 0.5%,

So, why exactly has the RBNZ been sending such mixed signals about inflation and interest rates over the last few months?

The Reserve Bank has an incredibly difficult task. Its mandate is “…formulating a monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices over the medium term.”

The challenge with this is that what the RBNZ does with the OCR doesn’t immediately flow through to inflation (and the economy)—according to a number of economists, it takes about 1 to 2 years.

Now, economies are naturally unpredictable, and external shocks can radically change the game in a very short space of time. Fiscal policy can also have a significant influence. This means that, at any given time, the RBNZ’s Monetary Policy Committee only has an ambiguous set of facts and forecasts to work with, on which they must base their monetary policy decisions.

In Australia, Westpac’s Chief Economist described the situation perfectly (talking about the Reserve Bank of Australia) in a recent article:

“The underlying logic of our framework is that monetary policy works with a lag. If you wait until you are back at target before starting to cut rates from a restrictive point, you have waited too long. So the question is how much evidence policymakers need to see to be convinced that inflation is on track to return to target on the desired timetable.” [emphasis added]

So, all up, I’d argue that the RBNZ does a pretty reasonable job. Whilst its mandate is simple (stability in prices), delivering on that in a complex and ever-changing economic environment is far from easy. 

And remember, as much as the RBNZ seems to have ‘flip-flopped’ over the last few months, so have many bank economists. Whilst some have been advocating for the easing of monetary conditions for quite some time (as I have), no one is infallible, and views can always change.

As the saying goes, “Harry Hindsight” is the world’s best trader.

That all said, I do think that the RBNZ’s ‘flip-flopping’ on interest rates—caused by a ‘miss’ in forecasts—could be mitigated by a series of changes to the makeup of the Monetary Policy Committee

Right now, the vast majority of the Monetary Policy Committee is made up of RBNZ staff.

And it’s their colleagues on the RBNZ economics team who are responsible for producing the RBNZ’s OCR and inflation forecasts, based on their read of economic indicators.

That dynamic makes it tough for a large proportion of the MPC to call it out when they think the RBNZ’s economists may have got it wrong, or are perhaps missing the nuances of what’s happening on the ground—which is why independent MPC members play such a vital role. 

In order to address this issue, I believe there are two changes needed to the way the Monetary Policy Committee (MPC) works.

1) Firstly, the Charter of the MPC needs to move away from a consensus-based approach.

In my experience, the scourge of committees is that they always tend to gravitate towards a central view, which can often be overly influenced by the opinions of one person or a specific group of people within that committee. 

Here’s what the charter says:

“The MPC will seek consensus in decision-making.  This is to ensure that the MPC engages in in-depth discussions and a true exchange of perspectives regarding monetary policy strategy.”

It goes on to say:

“Consensus refers to a decision which all members can support.”

Since the MPC was established in April 2019, this push for “consensus” has prevailed in almost every OCR decision. The one exception was in May 2023, when the vote was split 5-2 —with the majority calling for a 0.25% increase in the OCR, and the dissenting votes arguing for no change.

Are these decisions really that black and white, or do the RBNZ staffers hold undue influence over what the Committee does? 

At the time, the Governor, Adrian Orr, told Parliament's Finance and Expenditure Committee:

“On the division in the committee, the voting, there is no division. It's a committee decision.”

In my opinion, diversity of thought should be celebrated—and therefore that “division” in opinion should be encouraged.  

With that context, I believe that every OCR review should be voted on, and that the MPC Charter should be changed to something like:

“The MPC will seek in-depth discussion and robust debate, followed by a vote. The minutes of the MPC should reflect the varying views amongst Committee Members.”

2) The second thing that I believe should change is the composition of the MPC.

As I’ve mentioned already, the current makeup of the MPC is stacked with RBNZ employees: including RBNZ Governor Adrian Orr, plus three others. There are just three independent members, which means RBNZ staff are the majority.

Central banks around the world use a variety of models, a number of which have a majority of independent members:

• The Federal Reserve (the RBNZ’s equivalent in the USA) has seven members which are nominated by the president and confirmed by the Senate.
• The Bank of England has five employee members and four external members.
• The Bank of Canada Governing Council has six members who are all employees.
• The Reserve Bank of Australia (RBA) Board makes decisions about Australia’s monetary policy. It has nine members, of whom three are RBA employees and six are non-executive members. They make decisions by majority vote.
• The European Central Bank Governing Council includes six members of the Executive Board alongside the governors of all central banks from across the Euro area countries. That’s 26 members at last count!

IMAGE: European Central Bank Governing Council. Does anything stand out here? (Source: European Central Bank)

In my view, the structure of the RBNZ Monetary Policy Committee should be changed to ensure the majority are independent members—to encourage more diversity of thought.

So yes, whilst I believe the RBNZ does do a pretty good job, these two changes would (in my opinion) improve the operation of monetary policy in New Zealand.

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