BNZ economists see inflation moving above the RBNZ's target range; expect interest rates will need to be hiked to 5%

Inflation is likely to rise above the targeted 1% to 3%, prompting the Reserve Bank to hike official interest rates to 5%, BNZ economists are now predicting.

BNZ senior economist Craig Ebert said in an "Economy Watch" note that the bank was now forecasting stronger GDP growth than previously.

"...The overall consequence is greater excess demand than we previously envisaged," he said.

"This, in turn, will drive CPI inflation above the Reserve Bank’s 1% to 3% target band. To bring inflation under control, the bank will be forced to lift its Official Cash Rate (OCR) through neutral, to a braking level of 5%. This process will likely be reinforced by the NZ dollar struggling to hold its already very high level.

"If all of this sounds full on, it is supposed to."

Ebert's comments come ahead of the RBNZ's next review of interest rates on Thursday, March 13. The central bank is widely expected to change the level of the OCR for the first time in three years and actually raise rates for the first time in nearly four years. (The last OCR movement was a drop after the second Christchurch earthquake).

The expectation is that the RBNZ will lift rates to 2.75% from the current 2.5% as the first step in a cycle of rate rises. In its last set of forecasts (in December) running up to 2016 the RBNZ has to date suggested a peak in the OCR of about 4.5% or a little higher.

But Ebert said the BNZ economists are now forecasting real GDP growth of 4.1% for 2014 and 3.5% for 2015.

"This compares to the 3.9% and 2.3% we forecast previously. Our expectations for 2016 are down at 1.8%, from 2.2%. So we still have growth peaking this year, but at a slightly stronger pace and, more to the point, much less of a slowdown in 2015. Outright, this means sustained, above-trend, growth for a good couple of years.

"Why the upgrade? Well, some of it has to do with the fuller acceptance of the high level that net immigration has surged to and the way this has effectively doubled the rate of New Zealand’s annual population growth, to approximately 1.4%. We can’t see why this would turn tail anytime soon. While we had this substantively built into our labour market track, via working-age population assumptions, we felt we needed to do more to reflect this in GDP, via aggregate demand impacts."

Excess demand

Ebert said with a stronger phase of "excess demand" in prospect,  the BNZ economists were now forecasting the non-tradables component of the CPI to inflate to a 4.2% annual pace by early 2016, from last year’s 2.9%.

"This is countered, to some extent, by slightly lower inflation in tradables inflation, given the slower retreat we now project in the NZ dollar (more on that later). Totting these two parts up, we have CPI inflation getting to 3.1% by early 2016.

"While this is only 0.2 points higher than we saw before, it’s symbolically (if not significantly) above the 1.0 to 3.0% target band. And, just as importantly, it’s further away from the 2.0% mid-point that Governor Wheeler has said he is intently aiming to achieve."

This reinforced the belief of the BNZ economists that the Reserve Bank would be forced to "not just neutralise its stimulus, but get the OCR to a point where it’s actually having a braking effect on (excess) demand".

"We judge this level to be 5%. Pre [global financial crisis] of course, a 5% OCR was thought of as barely neutral. So, to be clear, we are accepting of the 'new normal' notion that New Zealand’s neutral cash rate is now more like 4-4.5% (assuming 2% inflation, that is).

"We previously projected the OCR peaking at 4.50%. But while we’ve since upped it, to 5%, we haven’t changed the time at which it’s achieved. That remains pitched at September 2015."

Hiking cycle

The BNZ economists are therefore now picking 25 basis-point moves in March, April and June, to 3.25%, then two more in September and December for an end-year 3.75%.

"In this there is an assumption the RBNZ will continue to lag. But come 2015, and relentless growth, and persistence of inflation pressure, we anticipate the RBNZ will add rate hikes at the April and July OCR reviews, to complement those at the March, June and September MPS meetings, in order to get to 5%," Ebert said.

He said the main downside risks to these projections were international and, locally, related to housing and this year’s election.

"The international risks are nothing new but, to repeat, involve commodity risk in relation to China’s importance on the trading front, and funding issues with respect to Europe’s ongoing banking uncertainties.

"The local housing market, particularly prices, will be a key test of how well, or otherwise, folk are prepared for rising rates (although we will also be monitoring reactions from businesses and farms, which also seem overly weighted to short-term debt and rates). The election, due by November, will be most important should it deliver a change to a left-leaning government. In the least, it may inject uncertainty."

Interruptions

Ebert said any of these things "could interrupt the OCR getting to neutral, let alone the 5% we are projecting".

"Of course, nor can we ignore the currency response to a greater than expected tightening cycle, lest it proves more than we anticipate as a base case." 

Ebert compared the BNZ' economists' latest view with the most recently available projections from the RBNZ.

"Using the [central] bank’s March-year basis, its December Monetary Policy Statement expected 2.8% GDP growth for 2013/14, 3.0% for 2014/15 and 2.3% for 2015/16. Our outlook is for 3.1%, 4.2% and 3.1% respectively. That’s a cumulative premium of 2.3%. No wonder, then, we are forecasting CPI inflation to get to 3.1% by early 2016, while the December MPS saw a more middling 2.2%.

"But it’s also why we should probably expect the bank to strengthen its macro-economic outlook in its Monetary Policy Statement of next Thursday. There certainly appears room and good reason for this to occur. And for the Bank to lift its (implied) OCR track in no small measure. Its December MPS, recall, inferred a 4.5% OCR by end-2015.

"Might this be lifted to 5.00%, even higher? It’s worth thinking about, and preparing for."