MNI INTERVIEW: Market Underpricing RBNZ Hike - Fmr Asst Gov

Markets have drastically underpriced the risk of a 25 basis-point hike to the Reserve Bank of New Zealand’s 2.25% official cash rate at next week’s meeting, a former assistant governor told MNI, arguing the oil shock will present policymakers with increasingly difficult trade-offs.

Pointing to overnight index swaps pricing implying around a 17% probability of a hike at the May 27 meeting, John McDermott, executive director at Motu Economic and Public Policy Research, said the risk of a move was considerably higher as the Bank grappled with oil-supply-driven price pressures. 

The updated Monetary Policy Statement (MPS) and refreshed forecasts provide a clear opportunity for the Bank to change course and begin raising rates again, particularly following recent comments by monetary policy committee member Prasanna Gai arguing the oil shock would raise the neutral interest rate, he added.

McDermott, who served as an RBNZ assistant governor until 2019, noted the Bank faces a difficult combination of rising inflation and weak economic activity, with higher energy prices effectively acting as a tax on households and businesses, rapidly eroding discretionary spending. While economic activity was already fragile before the shock, the oil-price surge is now pushing inflation further above the Bank’s 1-3% target band.

FASTER PASS-THROUGH

Gai’s recent remarks highlighted how the oil shock differs from a standard inflationary episode because oil sits at the centre of the production process, he said, affecting transport, energy, petrochemicals and a wide range of industrial inputs simultaneously. This would likely accelerate price pass-through across the economy and globally, complicating the standard Phillips curve framework typically used by central banks to assess inflation dynamics.

McDermott argued central banks are increasingly recognising this accelerated pass-through and that policymakers risk losing credibility if they continue with a “wait-and-see” approach. He pointed to recent comments by Reserve Bank of Australia Assistant Governor Sarah Hunter, who similarly warned the oil shock could feed through to prices more rapidly than in past episodes.

Markets may be struggling to fully price the implications of these technical arguments, McDermott said, with current pricing largely favouring a July move rather than action next week. "[The RBNZ] has a full MPS where they can lay out all these technical arguments and then explain its judgements on balance why it thinks the risk to inflation is more material for the decision relative to the weakness that we're going to see in the economy," he argued. "So it has all the architecture and the tools to explain a complicated argument. Why would you delay?" 

There is little significant economic data due between May and July that would materially reduce uncertainty or fundamentally alter the policy outlook, he noted. Waiting until July would therefore offer limited informational advantage while potentially increasing the risk inflation expectations become embedded.

McDermott called the Bank's earlier cautious stance in February, prior to the start of the Iran conflict. (See MNI INTERVIEW: RBNZ To Keep OCR Steady - McDermott)

PAST SHOCKS 

McDermott said the current environment resembles historical oil-shock episodes where policymakers ultimately paid a price for delaying action. With the OCR already below neutral — and potentially even further below if the neutral rate is rising — the argument for earlier tightening has become considerably stronger than markets currently assume.

At the same time, he acknowledged the RBNZ faces a delicate communication challenge given the economy’s persistent fragility. Policymakers would need to carefully marshal evidence and explain their evolving assessment to avoid generating unnecessary financial-market volatility, while still signalling that failing to respond to inflation risks could carry even greater costs.

"They’ll get some market noise if they move, but the market will get to a smoother point," he noted. "It's a very tricky because the economy is brittle. It started brittle. It's an adverse shock for businesses and households, so you're probably getting to a point where you want to get to a safe place of neutral, or just above neutral. You don't want the market to completely rip away, so it's a challenge."