RBNZ Governor Breman Speaks on Middle East War

Governor Breman emphasized that the RBNZ would be focused on medium-term inflation pressures, and that for now there’s little evidence these have lifted to suggest a need for near-term OCR hikes.

In a speech released this morning, Governor Breman emphasized that the RBNZ would be focused on medium-term inflation pressures, and that for now there’s little evidence these have lifted to suggest a need for near-term OCR hikes. The duration of the Iran war will be key.

Sticking to the playbook

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As foreshadowed last week, this morning  the RBNZ released the speech that Governor Breman will deliver to a business audience at 2pm today, and which will be discussed in scheduled meetings with economists and the media over the course of the day. The speech set out the RBNZ’s preliminary thoughts on the likely impact of the Middle East war on the New Zealand economy.

The key takeout is the RBNZ will look through the near-term first round impact of the oil shock on inflation and is therefore very unlikely to quickly jump to rate hikes. Rather, rate hikes will only be brought forward should there be an accumulation of evidence suggesting that the oil shock is generating second-round pressures on wages and prices, leading to higher inflation over the medium term. Those second-round effects – which are more likely to occur if the conflict is prolonged – are unlikely to be evident for some time.

As we discussed in an article released at the onset of the conflict, the RBNZ faces two-sided risks, rather than the one-sided risk that has been contemplated by markets. Key quotes from the speech that illustrate this point are:

• “We should try to avoid reacting too early to near-term inflation pressures that monetary policy can do little about – or reacting too late if above-target inflation becomes embedded in the economy.”
• “As a forward-looking Committee, we tend to look through first round direct and indirect effects and focus on medium-term second round effects.”
• “Higher production costs often result in squeezed margins and lower real incomes, and tend to dampen economic growth. A slowdown in growth may in turn dampen inflationary pressures over the medium term.”
• “Recent events do have some similarities with the last time we saw consumer prices increase quickly, such as regional conflicts, global oil price increases, and shipping disruptions in the Middle East. But there are also some important differences that could impact our outlook for medium term price pressures.”
• “….while the recovery has broadened, it is still in its early stages, and the New Zealand economy continues to operate below capacity. Household and business balance sheets are also more fragile, with less scope to absorb significant price increases. This means it may be harder for businesses to increase prices, and it could be less likely that short-term price pressures driven by supply-side shortages will become embedded in medium-term inflation.”
• “A short-lived disruption and a temporary increase in petrol prices can – and should – be looked through from a monetary policy perspective if it is unlikely to have an impact on medium-term inflation outcomes….The picture changes if this disruption is longer lasting; if there are longer-lasting impacts on global productive capacity or domestic demand; or if there is a greater risk of heightened oil and other import prices feeding into higher inflation expectations and inflationary wage- and price-setting behaviour.”

  The RBNZ is very much sticking by the playbook here by noting a bias to looking through what is currently judged to be a short-term supply shock. Monetary policy is poorly positioned to offset the short-term inflation impacts coming from the Iran war’s increase in oil prices and related supply chain impacts. The RBNZ’s focus on medium-term inflation pressures is entirely conventional, and the reality is that no one knows much about those right now.

  What is known is that this shock has come at a time when the economy was at an early stage of the recovery and excess capacity remains high. Hence the situation is very different from 2022 when the Russian war impact on inflation added further medium-term inflationary fire to an already hot economy. Breman appropriately notes this as something that gives the RBNZ some space to assess whether these short-term pressures will translate to medium term pressures.

  It’s unlikely the RBNZ will be raising rates in the next 6 months. It’s going to take time to work out how long this shock lasts, the impact on the economy and excess capacity and the implications for medium-term inflation pressures. OCR cuts similarly look unlikely while this assessment is being made.

  The reaction of the exchange rate may well be influential in determining what happens next. The New Zealand dollar could be very vulnerable in this environment given our weak growth, low interest rates and supply chain vulnerabilities. Should the NZD trend lower (as would be conventional for this type of supply shock) then the medium-term calculus may change. Real interest rates will be negative for quite a bit for a while – hence our view of OCR hikes over 2027 remain very valid. Global interest rates might well also be rising that year.

  The RBNZ will have more to say about the impact of the conflict on the economic outlook at the 8 April OCR Review which, as announced last week, will also be followed by a post-meeting press conference. It remains to be seen whether developments in the Middle East over the coming three weeks provide any additional clarity.