BNZ economists say they think the Reserve Bank would 'prefer' to hike the OCR by just 50 basis points rather than the 75 that is widely expected in the markets

BNZ economists think the Reserve Bank (RBNZ) would prefer to raise the Official Cash Rate by 50 rather than 75 basis points as widely expected in its next interest rate review on November 23.

However, in the BNZ's weekly Markets Outlook publication, BNZ head of research Stephen Toplis says that "if we were the central bank we would raise interest rates 50 basis points at the upcoming meeting, take the time between now and the next meeting in February to reassess, but probably throw in another couple of 25 basis points rate increases into the track, say February and May, to signal the direction of risk".

But he goes on to add: "We’re not, however, convinced the RBNZ sees things quite like we do.

"When push comes to shove, the determining factor for the Bank may well be what the market is pricing in the run up to the decision.

"We still reckon the RBNZ would prefer to go 50 if it could get away with it but it won’t want the currency to reverse its recent recovery and will not want to appear to be going soft on inflation."

At the moment the OCR is at 3.5%, having been raised by some 325 basis points by the RBNZ since the start of this tightening 'cycle' in October 2021. In each of the last five interest rate reviews the RBNZ has raised the OCR by 50 basis points. However, after annual inflation came in at a surprisingly scorching 7.2% for the September 2022 quarter, wholesale interest rate levels began 'pricing in' a 75 basis point rise at the next review - although this pricing has softened in recent days.

When it last provided in a forward 'track' of the OCR level in future months and years in August, the RBNZ had the OCR peaking at 4.1% next year. However, many economists - and wholesale interest rate pricing - now see the level hitting 5% next year.

BNZ's Toplis says the biggest issue the BNZ economists are are grappling with is, if the RBNZ was to hike 75, what would it do with its interest rate track?

"It would seem a bit odd to indicate no further move in February or even just 25 basis points for that matter.

"But were it to indicate 50 for February this would be a very brave call seeing that we could be staring down the barrel of a recession at that stage and, if the IMF is right, the rest of the world might not be that far behind us.

"Moreover, if you pencilled in 50 for February would you not have to throw another 25 into May for good measure? A track of 75,50,25 would put the terminal cash rate at 5.0%. We can’t help but think such a terminal rate would provide encouragement to a market already pricing in a peak of 5.1%. Would the Reserve Bank really want this?"

Toplis notes that in its recent Financial Stability Report the RBNZ  said that "the number of households in financial difficulty will grow as more fixed-rate mortgages reprice, and could increase significantly if mortgage rates rise materially above the servicing assessment rates of around 6% that banks applied through the pandemic period".

"In our opinion," Toplis says, "if the cash rate was to peak at 5.0%, substantially higher mortgage rates would almost be a certainty, especially given banks funding costs will also be pushed higher by increasing competition for term deposits due largely to the end to the Funding for Lending Programme [in early December].

"Don’t underestimate the impact of such elevated rates. In the words of the Reserve Bank, 'at an interest rate of 7%, we estimate that around 46% of 2021’s mortgage borrowers would need to spend at least half of their after-tax income on interest payments'!

"So the long and short of it is that a 75 point increase would result in a messaging headache for the Reserve Bank. This is a very good reason to avoid making such a move if at all possible."

Toplis says given all the information they currently have, the BNZ economists "are really struggling to get off the fence between 75 and 50".

"Right here and now we plum for 75 but this is a line ball call. For what it’s worth, the BNZ Research’s 'Monetary Policy Committee' voted 4-2 in favour of 75. We’d like to think of it as a 55%/45% call.

"With this in mind, we reiterate that market pricing could easily change these odds between now and November 23."