By Bernard Hickey
The Reserve Bank of New Zealand (RBNZ) has left the Official Cash Rate (OCR) on hold at 2.5% as expected, but it lifted its forecast for wholesale interest rates and warned more about inflationary pressures than economic weakness.
This prompted some economists to bring forward their expectatations of the first OCR hike to as early as December from January or March. Wholesale interest rates rose around 10-15 basis points and the New Zealand dollar strengthened almost a cent to 82.4 USc.
Reserve Bank Governor Alan Bollard later told Parliament's Finance and Expenditure Select Committee the market had "slightly over-reacted" to the forecast and had been "overly hawkish" in trading after the interest rate decision and the publication of forecasts. The currency dropped around a third of a cent after the comments and was trading around 82 USc in afternoon trade.
Releasing its June quarter Monetary Policy Statement (MPS), the bank said the economy was recovering after the shock of the February 22 earthquake in Christchurch and underlying inflation was expected to rise.
The RBNZ said a gradual increase in the OCR would be required over the next two years to offset this increase in inflation, but that it had left the rate on hold for now because underlying inflation remains constrained. It increased its forecast for the 90 day bill rate by around 25-30 basis points from its March MPS. See the chart below.
It sees the 90 day bill rate rising to around 4.8% by early 2013 from 2.6% now, implying an increase in floating rates would rise to just under 8%.
The RBNZ also commented that the strength in the New Zealand dollar was negatively affecting exporters and constraining the rebalancing of the New Zealand economy towards exports and away from consumption and borrowing.
However, it made no comments in the MPS about intervening to push the currency lower. The RBNZ intervened to push the New Zealand dollar lower in mid 2007 when the trade weighted index pushed above 75. The TWI is still only just above 70, despite the New Zealand dollar being higher against the US dollar than it was then. The Kiwi has weakened vs the Australian dollar since then.
“The outlook for the New Zealand economy has improved since the publication of the March Statement," Reserve Bank Governor Alan Bollard said.
“Economic activity has been significantly disrupted by the Christchurch earthquake. However, while many firms and households – particularly within Canterbury – continue to be adversely affected, it appears the negative confidence effect of the earthquake on economic activity throughout the rest of the country has been limited," Bollard said.
“The early signs of recovery noted in the March Statement have continued. Despite some continuing signs of weakness in the world economy, commodity prices remain very strong and firms expect to increase their hiring and capital investment. Reconstruction in Canterbury is projected to add about 2 percentage points to GDP growth over 2012, and boost the level of activity for several years thereafter," he said.
“Despite the strong outlook for export earnings, household expenditure is expected to grow only modestly. Household debt remains very high and is expected to constrain retail spending and the housing market for some time. Continued fiscal consolidation will also act to dampen activity."
'Currency over-valued'
The Reserve Bank commented the New Zealand dollar had appreciated substantially over the past two months.
"This appreciation, supported by high export prices for primary producers, is negatively affecting other parts of the tradable sector, constraining rebalancing of the New Zealand economy," Bollard said.
He added in a subsequent news conferencen that the currency was over-valued, but he said he was reluctant to intervene as it did not change the long term direction for the currency.
See my comment piece here on the RBNZ doing nothing to stop New Zealand's propensity to borrow overseas and sell assets to pay for unsustainable spending.
'Inflation building'
“Headline inflation is currently being boosted by recent increases in indirect taxes, food and petrol prices, and surveyed expectations of future inflation have edged up. Despite this, indicators of capacity usage and core inflation suggest underlying inflation remains constrained," Bollard said.
“As GDP growth picks up, underlying inflation is expected to rise. A gradual increase in the OCR over the next two years will be required to offset this, such that CPI inflation tracks close to the midpoint of the target band over the latter part of the projection. The pace and timing of increases will be guided by the speed of recovery, but for now the OCR remains on hold.”
Economists react
Westpac economist Dominick Stephens said the RBNZ had altered its stance on future monetary policy and he now expected the RBNZ would hike in December, rather than the January he had previously forecast.
"Both the press release and the Monetary Policy Statement were firmly focussed on the upcoming surge in economic activity, combined with strong export commodity prices, that would together put upward pressure on inflation. This stood in marked contrast to the March and April Statements, which tended to focus more on the potential downside risks stemming from earthquake-related disruption," Stephens said.
'We have long been signalling our expectation for a steep and long-lived series of interest rate hikes - that expectation remains unaltered. In particular, we are very sceptical that the peak in 90-day rates will be as low as 4.9%, as implied by the RBNZ's projections," Stephens said.
The RBNZ appeared to have much greater faith in the longevity of New Zealand's terms of trade boom, Stephens said.
"And naturally, if one is more comfortable with NZ's strong external position, one becomes more comfortable with the high exchange rate. This appears to be the Reserve Bank's new position. The TWI is now forecast to remain above 65, helping to keep inflation low," he said.
"The Statement emphasised upside risks to the relatively hawkish projection. In particular, the RBNZ outlined three important judgements – that construction costs would remain contained, that New Zealanders would continue to focus on paying off debt, and that increases in inflation expectations would be short-lived. The clear implication is that if these judgements are wrong, rates could rise sooner and/or faster than projected. Unsurprisingly, the Statement gave most attention to the risks around inflation expectations, reiterating that the RBNZ has been monitoring inflation expectations ‘even more closely’ since last year’s GST increase."
The 2 year swap rate rose 14 basis points, Westpac said.
BNZ Economist Stephen Toplis said he was sticking to his picks for 25 basis point rate hikes on December 8, January 26 and March 8.
Today the Reserve Bank woke up to the fact that the New Zealand economy is, indeed, on a relatively firm footing, despite the Christchurch earthquake," Toplis said.
"And with that firm footing comes heightened inflation risk. Accordingly, while maintaining the cash rate at 2.5%, the Bank issued a clear warning that the first hike in interest rates is not only getting closer by the day but that when that hiking process starts it will be more aggressive than it, and the market, had been anticipating."
ASB economist Nick Tuffley said the Reserve Bank now seemed more concerned about inflation and he also pulled forward his OCR hike forecast. He now saw a January hike rather than a March one.
"The RBNZ has become more comfortable that the wider economy is starting to pick up but less comfortable about the inflation outlook. Both of these factors raise the risk of an earlier tightening than we have previously thought," Tuffley said.
Tuffley said he expected a higher currency than the RBNZ expected.
"Despite the frustrations of a strong NZD, there was no hint of a desire for intervention in today’s announcement," Tuffley said.
The RBNZ’s own interest rate forecasts now implied a first hike as early as December, he said.
"That is where the risk lies. Signs of a brisk recovery would quickly reduce the need for the insurance cut put into place after the February earthquake. The RBNZ’s nervousness about inflation expectations is another potential trigger of an early hike: if inflation expectations remain elevated between now and the November survey then a December hike would be very likely," he said.
"We still judge that the RBNZ has time to wait, and will need time to wait for certainty about recovery and reconstruction. Last year was a lesson about lifting interest rates too soon. And there is still far too much uncertainty about Christchurch’s reconstruction for the RBNZ to have a clear picture of when inflation from that source will appear. That uncertainty is unlikely to be resolved sufficiently for a number of months. Importantly, we think the reconstruction risks being less rapid than the RBNZ assumes. If so, the RBNZ will likely rethink the monetary policy implications."
"Finally, the preponderance of floating mortgage rates and steep yield curve means monetary policy’s bite will be relatively swift and effective. That gives the RBNZ some leeway, and some comfort, should it become apparent that inflation is getting up a larger head of steam than currently forecast. Our January call is later than the market is pricing in, for the above reasons. It comes conveniently after Q3 GDP signal the extent to which activity is growing once the initial earthquake disruption abates. "
"December is the main risk to our call, if the recovery and reconstruction appear on track to meet RBNZ expectations. But any earlier than December is far too soon to resolve uncertainties about the reconstruction impact on inflation, or the persistent of the recent lift in inflation expectations. But once tightening starts, we expect the persistent nature of inflation drivers to prompt sustained OCR increases to 4.5%."
Tuffley said the market had moved to fully price in a 0.25% rate hike from the RBNZ by the end of 2011, and expects rates to be around 3.75% based on December 2012 OIS prices.
ANZ economists said the RBNZ's upward revision in its 90 day bill rate projection triggered a rise in swap rates and the New Zealand dollar. The strong currency had been subtly endorsed, ANZ's economists said.
"The new track is roughly 25bps higher than the March forecasts by the end of 2012, but importantly this is around 50bps higher than market pricing had been," ANZ said. "The 90-day track also implies a December start to the tightening cycle, which is in line with our view but was not fully priced by the market – until today."
ANZ economists said they struggled to see inflation heading down towards 2% as the RBNZ forecast.
"There is much discussion in the Statement on inflation expectations, a lot more than usual. For now, the RBNZ is looking through the recent spike, putting it down to high petrol prices, which have since subsided. But should inflation expectations stay high, the RBNZ will not be able to ignore this," ANZ said.
"The RBNZ notes that “indicators of excess capacity are mixed, with some suggesting that there is less slack in the economy than might be expected given this weak activity picture.” Our view is that the economy has a lower margin of spare capacity, given the lack of investment over the past few years, which is why we think inflation pressures will emerge sooner rather than later."
ANZ's economists said the RBNZ was aware that last year’s surge in confidence proved to be a "head fake."
"The RBNZ will not want to make the same mistake again in reacting to confidence readings only for the recovery to fail to take hold. The upward sloping yield curve and high proportion of mortgages on floating rates give the RBNZ confidence to sit on the sidelines for longer."
They said there was no active attempt by the RBNZ to try to jawbone the currency down – either in the statement or during the Governor’s press conference.
"This suggests that the RBNZ may be fairly relaxed about the current level of the currency."
ANZ economists said they were happy to stick with their forecast for a 25bps hike in the OCR in December view, but "we wouldn’t rule out the first move being a 50bp increase."
"This goes against the grain of “gradual” rises in the OCR and should not be confused with us becoming overtly hawkish. We expect slow and steady rate increases beyond that and a sub 5 percent OCR endgame. However, a 2.5 percent OCR simply looks inconsistent with the growth and inflation outlook, and we expect the tenor of data from July in particular to increasingly bear this out."
Fed Farmers warns on rates and debt repayment
Federated Farmers warned farmers to prepare for higher interest rates, partly because of the Reserve Bank's comments and partly because of a tightening of rules on capital for bank lending to farmers. See Gareth Vaughan's article on the bank lending rules.
“The hold is not a surprise although the more bullish outlook and a clear signal that tightening will come, possibly is,” says Philip York, Federated Farmers economic and commerce spokesperson.
“Well before the Reserve Bank begins a tightening of monetary policy, farmers may see an increase in the cost of borrowing. This is in response to new Reserve Bank capital adequacy ratios for farm lending. The cost of any increases will be watched closely by Federated Farmers," York said.
He reiterated that farmers were likely to repay debt with the proceeds from the export boom rather than go on a spending spree.
“Given farmers will prioritise debt reduction in order to bank an increasingly bright commodities picture, we restate our firm belief commodity income will not be a threat to inflation," York said, adding on-farm inflation remained a problem and the government needed to reduce spending and borrowing to reduce the upwards pressure on the currency," York said.
“The big concern is that those outside the farm gate are anticipating windfalls that won’t come, as farmers grapple with gearing ratios and increasing costs of borrowing," he said.
“The best way to bring down the dollar is for Government to constrain its spending and with it, the borrowing programme."
HSBC economist John Bloxham said there was now a chance of a rate hike earlier than the December quarter.
"Six weeks have gone by and the Governor has shifted his tone from rates are on hold for ‘some time’, to rates are on hold ‘for now’. What will another six weeks bring?," Bloxham said.
"The case is building for a reversal of emergency rate settings. We still expect the next hike in Q4, but the risk is for an earlier move," he said.
(Updates with new video, more detail, NZ$ and swap rate reaction; Westpac economist's comments; BNZ economists comment; ASB economists' comments; ANZ economists' comment; HSBC economist's comments; Bollard comments in FEC committee; chart showing slightly higher RBNZ forecast for 90 day bill rate from March MPS; Fed Farmers comments; link to full MPS, link to my comment piece)
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