‘Path Of Least Regret’: New Zealand, Canada Send A Message

New Zealand took “the path of least regret” on Wednesday, when RBNZ opted for a 50bps rate hike, the largest increase in more than two decades.

Just five of 20 economists predicted the outsized move, even as markets assigned high odds to a larger increment as the bank seeks to extinguish a raging inflation inferno. Inflation is seen peaking at 7% this quarter, but the chances of entrenched price pressures are rising via the expectations channel.

The rationale, as detailed in the new statement, might serve as a template for the bank’s global peers. It’s better to hike “more now, rather than later, to head off rising inflation expectations and minimize any unnecessary volatility in output, interest rates and the exchange rate in the future,” RBNZ said, calling the largest hike since 2000 “consistent with this least regrets analysis.”

The figure (below) is the history of OCR by meeting. Note that New Zealand has been a DM first mover during this tightening cycle, if you don’t count the Norges Bank, whose circumstances are anomalous in some ways. RBNZ would’ve hiked in August, but a snap COVID lockdown pushed the move to October.

“Members noted that inflation is above target and employment is above its maximum sustainable level,” the statement went on to say. “As such, the Committee confirmed that further increases in the OCR are needed in order to meet their mandate.”

RBNZ faces the same quandary as every other monetary policymaking body in the developed and mostly-developed world: How to tighten aggressively without undermining the economy. Critics of the Fed’s “patient” approach argue the correct course was to hike early in order to reduce the necessity of rapid tightening later, which might cripple growth. Effectively, many argue the Fed should’ve taken the path of “least regret” last year.

The Bank of Canada also hiked 50bps on Wednesday (figure below) and announced the onset of QT. “CPI inflation is now expected to average almost 6% in the first half of 2022 and remain well above the control range throughout this year,” the BoC said, warning of “an increasing risk that expectations of elevated inflation could become entrenched.”

Tiff Macklem said Canadians “should expect interest rates to continue to rise” until they return to “more normal” levels, where that means close to the bank’s estimate of neutral between 2% and 3%. Macklem also said “we may need to take rates modestly above neutral for a period,” even as he simultaneously said a “pause” is possible depending on conditions.

“An increasing number of central banks refuse to take risks with rising inflation expectations,” ING’s Chris Turner said. “This was the type of front-loaded tightening that had been seen in the central banks of Brazil, Russia and the Czech Republic last year and is now making its way into the developed market space.”

The RBNZ hike, New Zealand’s fourth consecutive, was described as “dovish” by some. A decision to bring forward the bulk of the tightening ostensibly means fewer hikes later. I’m not sure that’s the correct read — or at least not if you’re trading it as NZD negative. RBNZ plainly wants to get OCR to 2% (roughly neutral) posthaste, and they’ll move well beyond that in fairly short order. “Rising inflation expectations threaten RBNZ’s mandate and credibility, something [they’re] clearly unwilling to accept,” Kiwibank chief economist Jarrod Kerr said.

Kiwi weakness was attributed in part to options. “NZD was already under pressure from short-term funds exiting long positions after RBNZ raised rates by 50bps, but with spot falling under 0.6850 it is also triggering option investors with negative gamma positions to sell spot as they try and defend their losing positions,” Bloomberg’s David Finnerty remarked.

Wednesday’s hike brought the four-meeting total to 125bps (figure below). Assuming additional front-loaded hikes and a continuation of RBNZ’s “least regrets” approach, investors may judge the terminal rate to be slightly lower amid a very aggressive central bank. Bond yields tumbled.

“A greater hike now reduces the chance of a larger increase later,” one local FX strategist said. Markets expect another 50bps hike in May.

The bank’s projected rate path was unchanged. 3.25% is the forecasted peak. Again, the point is to rapidly move to neutral in order to… well, in order to neutralize the expectations channel, thereby reducing the odds of a further overshoot. “A larger move now also provides more policy flexibility ahead in light of the highly uncertain global economic environment,” RBNZ remarked.

Ultimately, RBNZ’s approach and Canada’s upsized move should have a signaling effect. The Fed does enjoy one advantage from being “late,” though: Jerome Powell will get to observe the impact of rapid tightening in other locales as he nudges US rates higher. New Zealand, Canada and the UK are Petri dishes.

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