David Hargreaves examines the coming week's Reserve Bank Official Cash Rate review, the first for three months, and one that will see the RBNZ probably juggling between either a large, or extra-large OCR hike. But what about the weather?

If the Reserve Bank had hoped the three month summer break between Official Cash Rate reviews would help clarify the way forward in the inflation battle, well, it is likely to have been disappointed. Very disappointed.

The opposite has probably been the case, with conflicting signals emerging around the economy and making the RBNZ's inflation-busting task arguably even more complicated than it already was. And that's before we even talk about the weather...

I'm making the perhaps brave assumption here that I think for the moment - till more clarity emerges about all the economic impacts of the weather events - the RBNZ will carry on with its earlier signalled course. Inflation will remain number one priority. And let's face it our weather woes are likely to be inflationary, anyway. Just what the RBNZ didn't need.  

So, in terms of the here and now, it appears that the debate within the RBNZ in the run-up to the release of the new Monetary Policy Statement (MPS) and OCR review on Wednesday, February 22, will be around whether our central bank should increase the key interest rate by 50 basis points or go for another 'jumbo' rise (matching the one in November 2022) of 75 points. 

The only reason we can say that with any conviction is because the financial markets are anticipating either a 50 or 75-pointer, with current money at time of writing more on 50. Therefore, if the RBNZ delivered anything different it might get the wrong kind of reaction, which would then be unhelpful in its inflation battle.

The RBNZ doesn't have to abide by what the market thinks at all - but at the moment it's better if our central bank does stay on the same page. The last thing it would want is for the markets to, for example, start driving down wholesale interest rates, which could then begin pushing mortgage rates down. More on that theme further down the article.

In terms of what the economists are thinking, most of the major bank economists are now leaning toward a 50 point rise. However, Kiwibank economists, while not expecting the RBNZ to pause because of the weather impacts, have said that it should.

Whatever the RBNZ decides between a 50-point OCR hike and a 75-pointer, however, there's going to be a great deal of head scratching about where to go from here.

In very simplistic terms the RBNZ wants to see our ultra-tight jobs market loosen and develop some 'slack' (yes, including by implication rising unemployment) and a slowing of consumer spending. This will then lead to a general cooling of the economy and easing of inflationary pressures.

At the end of last year there appeared to have been some signs that the central bank was starting to get the desired results.

December quarter inflation came in at an annual rate of 7.2%, unchanged from September. But importantly the key domestically-generated inflation figure remained at 6.6%, when the RBNZ had expected much more at 7.0%. 

Unemployment for the December quarter rose to 3.4% from 3.3%, against expectations. The RBNZ had forecast a fall in the unemployment rate to 3.2%. Average hourly private sector wages had an annual rise of 8.1%, against the RBNZ's forecast of 9.1%.

Also in December there was a marked drop in job adverts, and electronic card transaction data showed a reasonably sharp (seasonally adjusted) fall in spending.

However, moving into the New Year, we've seen job ads increase again and the latest electronic card transaction data showed quite a rise - 2.6% - in January. Spend, spend, spend! So, contradictory signals.

Source: 123rf.com. Copyright: jokiewalker

And then there's the weather. These 'events' we've been having in January and into this month make an already unclear economic picture even more murky. 

If, for example, you need to go out and buy a new carpet, this will boost spending figures and it may likely also be inflationary, since it's not hard to imagine shortages if a lot of people all suddenly need to buy new carpets. 

Then there's lost production, food and grocery shortages, need to repair infrastructure etc. All inflationary.

The RBNZ's happy to 'look through' one-off inflationary impacts, but I can well imagine the one-off impacts from the appalling bout of weather are going to be quite hard to differentiate in terms of the overall inflation picture.

We could see both sides of the economic equation occurring here too. There's the aforementioned spending boost and inflationary impact of a sudden surge in, for example, durables buying, along with supply chain problems leading to increased prices in a whole range of areas. But then there's also the prospect that we could see a simultaneous pull-back in spending due to the damage and costs associated with the weather. It is, dare I say, a recipe for the dreaded 'Stagflation'.

This is all a nightmare for the RBNZ, which is wanting to see some sort of pattern emerge that tells it whether its efforts to curb inflation are starting to work. It needs to have 'good visibility' on what's happening in the economy, so, that it neither undercooks nor overcooks its interest rate hikes.

One helpful development for the central bank in the past week has been the results of its own Survey of Expectations, which showed a drop in the expected inflation level in two years time. The point about that survey is not whether the expectations are accurate or not. They key thing is that the survey acts as a test of the RBNZ's credibility in achieving its target of reining in inflation into a 1% to 3% range. If inflation expectations soar, it means the respondents to the survey don't think the central bank has got the inflation target under control. If the inflation expectations fall this indicates that the survey respondents think the bank is heading back in the right direction in terms of getting on top of inflation.

So those survey results were helpful for the RBNZ and will give it the impression it is getting to grips with the situation. 

However, for now, the central bank's 'least regrets' approach will, I think, see it continue to do what it thinks it needs to in order to get inflation back towards its 1% to 3% target range. Hence therefore the expectation of either a 50 point or 75 point rise to the OCR, taking it from the current 4.25% to either 4.75% or 5%.

Source: 123rf.com. Copyright: marog

But then what?

At the moment, based on its November MPS, the RBNZ is forecasting a peak OCR of 5.5% by the middle of 2023. As ever there will be huge interest in what its new projections for the path of the OCR will be when it releases its new MPS on this coming Wednesday. Some economists are thinking the central bank may trim its estimate of the peak OCR back to 5.25%. 

If it does that and we assume a 50 point rise to the OCR on Wednesday, this will make the OCR 4.75% and the RBNZ has just another 50 basis points left to play with. The peak could be reached quite soon, before the halfway point in the year.

As I wrote recently, once the perceived top of the rate hiking cycle has been reached, that's when it gets quite tough for the RBNZ. It may be faced with a situation in which it doesn't particularly want to raise the OCR further, but it doesn't want retail interest rates, particularly mortgages, starting to actually fall either. And that might happen once the wholesale interest rate markets feel an OCR peak has been reached.

The RBNZ will clearly want to indicate to the markets that it doesn't envisage (want) interest rates coming down for some time. How the central bank does this once it looks as though it is getting to the end of the interest rate hikes will be crucial. Fail to get that message across convincingly and the RBNZ risks the markets themselves pushing interest rates down and effectively 'easing' monetary policy. Could happen. 

Actually, the above is one reason why I think the RBNZ should really be looking now at 'just' a 25 point rise in the OCR this coming Wednesday - albeit that I don't think it will do that. The RBNZ is getting to the point where it may need some flexibility, the ability to throw in a maybe surprise hike to off-balance the markets if needed. The more perceived 'headroom' it has between the current OCR level and the perceived peak then the more flexibility it has.

Of course, I would stress that there's nothing at all to stop the RBNZ taking the OCR much higher still if it feels it needs to. But I've long since suspected the RBNZ would probably prefer to see mortgage rates not going much higher than they are.

The thing is though, it just doesn't want to see them coming down, yet, from these levels.

Anyway, in the immediate future, Wednesday will most probably bring either a 50 or 75 point rise and some continued fairly 'hawkish', work-to-be-done language from the central bank. It's a coin toss but I think the easier inflation expectations recorded in the RBNZ survey (as further up in the article) might just have been enough to tip the balance to 50.

Beyond that we will then have to wait and see what happens with the economy and whether it will cool and take the heat out of inflation.

Nothing can be taken for granted at this stage.

*This article was first published in our email for paying subscribers early on Friday morning. See here for more details and how to subscribe.