Mark Lister, 11 February 2019

Things seem to have changed substantially in the world of interest rates in a few short months.

Last year we were all preparing for “normalisation”, as central banks had started withdrawing the extreme stimulus of recent years.

The Federal Reserve in the US was the key protagonist. The Fed hiked interest rates four times in 2018, taking its benchmark cash rate to 2.5 per cent, the highest in more than a decade.

This looked set to continue in 2019, with Fed Chair Jerome Powell saying as recently as October that the Fed was “a long way” from getting rates back to neutral.

The tough talk has changed though, and this year the Fed has been decidedly more cautious. Powell has suggested the need for patience, and has dropped the comment about "further gradual increases" being necessary.

It also seems to have changed its tune regarding its balance sheet, which increased dramatically during the quantitative easing years and has been gradually shrinking as this process has begun to work in reverse.

After telling us late last year that this balance sheet normalisation process was on "autopilot", the Fed now tells us it could be adjusted or stopped completely, if conditions warranted so.

Financial markets have taken note, with longer-term interest rates in the US falling and expectations of more rate hikes having dried up completely.

The turnaround doesn’t seem to be due to the US economy, which has slowed a little but is by no means in trouble.

The January jobs report was much stronger ahead of expectations, while a key manufacturing indicator rebounded on the back of increases in new orders, production and employment.

A better bet is probably the almost 20 per cent fall we saw in the US sharemarket during the last few months of 2018.

Financial markets are important, as is confidence, so it’s sensible of the Fed to take note of these moves. At the same time, we don’t want the central bank to be at the whim of investor demands, otherwise we’ll never get back to anything resembling normal.

This change in tone we’ve seen offshore has filtered back to New Zealand as well. Ahead of our own Reserve Bank meeting this week, financial markets now put the likelihood of a cut to the OCR by July at 40 per cent. Over the coming 12 months, they see one as a certainty.

Sure, things have been mixed over the last few months. The December unemployment report was a little softer than expected, we now know migration hasn’t been as strong as we thought, and international risks have undoubtedly increased.

However, domestic inflation has been marginally stronger, business confidence has stabilised and dairy prices are up almost 20 per cent since November.

Potential changes to bank capital requirements will be weighing on the minds of some economists, and while these could ultimately increase the need for OCR cuts, that’s not a 2019 story.

Against this backdrop, it’ll be interesting to see whether the new economic forecasts from our Reserve Bank have changed as dramatically as financial market expectations seem to have.