Forget Fed Minutes. Watch New Zealand Next Week (February 20, 2024)

New Zealand’s Central Bank could resume rate hikes next week. What New Zealand does will give context to how the Fed may respond to renewed inflation concerns in the U.S.

By Lisa Beilfuss

How realistic is a scenario where the Federal Reserve lifts interest rates again before cutting them? An inconspicuous clue may come next week.  

Higher-than-expected January consumer prices, producer prices and import prices have traders all but abandoning expectations that the Fed will begin slashing rates in March, with bets now pushed out to a summer start. What is more, the data are stirring discussion around the possibility of renewed tightening this cycle as inflation shows signs of reemerging. 

One month of data isn’t much and economists warn of seasonal distortions. But the January inflation figures don’t seem to be anomalies. Home prices are rising and energy is rebounding. Nominal annual wage growth is settling around 5%. Lending standards are improving, M2 money supply is up 2% since bottoming in October and M2 velocity–how fast money moves through the economy–has risen for nine straight quarters.

As Citi economists Andrew Hollenhorst and Veronica Clark put it, “the U.S. economy has entered a new regime where inflation is more elevated and more volatile.” 

Former Treasury Secretary Larry Summers goes a step farther. In the wake of the latest inflation data, he said there is “a meaningful chance” that the Fed’s next move is going to be upwards in rates, not downwards. While renewed tightening seems to be virtually no one’s current base-case scenario, it is a tail risk worth considering. Summers, for his part, puts odds at 15%. 

As for the base-case: The recent bout of rising inflation data and headline strength in the job market will change the timing and number of cuts–but not the direction of monetary policy–says Joseph Wang, CIO of Monetary Macro. 

Wang notes that Fed officials have articulated a framework that views policy through the lens of real, or inflation-adjusted, interest rates and a neutral rate that is little changed from the pre-pandemic period. Such a framework requires rate cuts in line with declines in inflation expectations to avoid overtightening, Wang says. He concludes that the Fed’s reaction function still points towards cuts, with an inflation upturn translating to fewer cuts than anticipated by markets broadly.  

Minutes from the Fed’s January 31 meeting, due out Wednesday afternoon, may shed light on how officials were thinking about the timing and number of rate cuts before the latest inflation data–helpful if the upturn winds up a blip. But for hints about an outside risk of renewed hikes in the U.S., investors should look to New Zealand next week.  

New Zealand’s Central Bank, the Reserve Bank of New Zealand, has a history of leading other central banks. The RBNZ was the first to hike and the first to pause this cycle, leading the U.S. Fed, notes Jim Bianco of Bianco Research. Going back much farther, the RBNZ created the 2% inflation target that many global central banks eventually adopted.

“They are a forward-looking central bank consistently doing things before everyone else,” Bianco says.

Earlier this month, ANZ Bank New Zealand chief economist Sharon Zollner issued a research report predicting that the RBNZ would hike its main policy rate by 25 basis points in both February and April, taking it to 6%. She acknowledges it is a call that sounds “bananas,” but her logic is instructive for U.S. investors. 

“No one piece of data is to blame but a series of small, unwelcome surprises,” says Zollner. “We just don’t think the RBNZ will feel confident they’ve done enough to meet their inflation mandate.” 

There are of course big differences between the U.S. and New Zealand. One is that the country’s GDP is roughly equivalent to the state of Utah’s. Another is that the current policy rate in New Zealand is still well off its peak rate of 8.5% heading into the Great Financial Crisis. In the U.S., rates then topped out at 5.25%. Yet another: New Zealand isn’t heading into an election, unlike the U.S. where policy this year may not escape politics. 

Still, Zollner’s call is based on conditions in New Zealand that should sound familiar to U.S. investors. Among the surprises she lists: higher-than-expected CPI; a lower-than-expected unemployment rate; higher-than-expected net migration; sticky high-frequency price intentions; and immense fiscal stimulus. At the same time, so-called green shoots are emerging precisely because of a widespread expectation that rates have peaked.

She lays out the two-sided risks facing the central bank. Hike, and the worst-case scenario is that the lagged impacts of previous tightening are just about to bite. Don’t hike, and the worst-case scenario is that inflation is actually really quite embedded. As Zollner sees it, there is no way to avoid exacerbating one risk or the other. Ultimately, though, the latter worst-case scenario would be much more painful than the former.

Zollner makes the point that the central bank probably wouldn’t restart the hiking cycle for the sake of 25 basis points. The upshot she lays out is worth considering given the booming stock market and tight credit spreads in the U.S., indications that financial conditions aren’t very restrictive. 

“The shock value of restarting hiking and re-establishing uncertainty about how high rates might go could have a chilling impact on the housing market and investment beyond what ’50 basis points’ would normally mean,” she says. “That wouldn’t necessarily mean more hiking wasn’t needed. It could just mean it was really effective, and did its job unusually fast.”

A rate hike next week in New Zealand doesn’t mean the Fed will quickly follow suit. Nonetheless, how New Zealand responds to  stubborn inflation may give U.S. investors a read on how the Fed will proceed in the near term. It seems fair to assume the Fed has a bias toward cutting, given the new asymmetrical average inflation-targeting framework that tolerates above-target inflation more than rising unemployment and because of an emphasis on real rates. But a pivot by the RBNZ will draw attention to the tail risk of more Fed hikes. At the very least, a hawkish surprise in New Zealand may throw even more cold water on current Fed cut expectations.