RBNZ hikes OCR 25 bps to 3.25% as expected; leaves forecast track for interest rate rises unchanged

By Bernard Hickey

The Reserve Bank of New Zealand has increased the Official Cash Rate (OCR) by 25 basis points to 3.25% as widely expected, but has left its forecast track for a rise in short term interest rates to over 5% by early 2016 broadly unchanged.

Financial markets had been pricing in a slightly lower track for interest rates over the next two years. The New Zealand dollar jumped around half a US cent to 86.2 USc on the news.

The Reserve Bank also raised the prospect that a surge in net migration beyond its current forecasts could lift house price inflation by four percentage points, and force the bank to raise interest rates by a further 55 basis points. Governor Graeme Wheeler later downplayed the prospect of using migration controls to reduce the impact on the economy, saying migration was too volatile to be able to successfully micro-manage the effect.

Governor Graeme Wheeler said GDP was estimated to have grown 4% in the year to June and the economy's expansion had considerable momentum as strong construction spending in Christchurch and elsewhere was supporting growth and offsetting any fall in commodity export incomes.

"While house price inflation remains high, the housing market has moderated since late last year when restrictions were applied to high loan-to-value ratio mortgage lending and when mortgage interest rates began rising," Wheeler said.

"Fiscal consolidation continues to moderate demand growth, though by less than previously assumed," Wheeler said.

"The exchange rate has not yet adjusted to weakening commodity prices, but is expected to do so. The Bank does not believe the exchange rate is sustainable at current levels," he said.

The bank made no comment in its Monetary Policy Statement to follow up the Governor's suggestion in a recent speech that the Reserve Bank might intervene to push the currency lower. Governor Wheeler later told a news conference the bank continued to use its 'traffic light' system for judging if and when to intervene, but he declined to say if the bank was considering intervention now.

Wheeler said above-trend growth had been absorbing spare capacity and adding pressure to non-tradables inflation, particularly for construction costs.

"Nevertheless, overall wage inflation remains moderate, reflecting recent low headline inflation, increased labour force participation and strong net immigration," he said.

"Inflationary pressures are expected to increase. In this environment, it is important that inflation expectations remain contained and that interest rates return to a more neutral level."

Wheeler repeated previous comments that the OCR needed to rise and its future rises would depend "on future economic and financial data, and its implications for inflationary pressures. "

"By increasing the OCR as needed to keep future average inflation near the 2 percent target mid-point, the Bank is seeking to ensure that the economic expansion can be sustained," Wheeler said.

News conference details

In the news conference after the release of the statement, Wheeler was asked if the bank's decision not to lower its forecast track for interest rates was designed to send a hawkish message to markets.

"There's still strong momentum in the economy," he said, pointing to a 50% increase in residential investment over the three year period from 2013 to 2016 and strong net migration.

"We still see inflation pressures associated with the economy growing above trend rates of growth. We think potential output growth in the economy is probably around 2.75% and over the next 12 months we're forecasting growth of around 3.5%, so we are starting to see pricing pressures in the non-traded goods sector, particularly around construction and some of the other services sectors," he said.

Wheeler was then asked if he would like to see the Government change migration policy to take pressure off the economy and interest rates.

"Migration is in many things a very positive force for the economy, particularly if it involves increasing skilled labour. There are demand and supply side effects," Wheeler said.

"The historic experience is the demand-side impact tends to come through first in the economy and that will be reflected in higher housing demand. What we're seeing this time is that maybe the impact on aggregate housing demand may not be as strong as, for example, the 2002 to 2004 cycle because a lot of the net migration is due to New Zealanders staying rather than departing the country and also a lot of the arrivals are tied in to temporary work permits," he said.

"So it's possible we won't see the same dramatic impact on house prices we saw in 2002 to 2004."

Wheeler was then asked about the Labour proposal to control migration to take pressure off interest rates.

"It's very hard to fine-tune immigration to meet demand purposes. By the time you make an adjustment you may well find the situation has completely changed," he said.

Other interesting figures

The Reserve Bank is forecasting dairy prices will fall another 12% over the next 12 months, having already fallen 26% since February. This would reduce dairy farmer income by around NZ$2.25 billion over the next year, or about a 1% decline in real incomes.

The bank is forecasting an increase in the working age population over the coming years of 100,000 or 3% due to migration. This compares with a cyclical increase in migration from 2002 to 2004 of 70,000.

New Zealand's household savings rate has averaged minus 2.75% of disposable income for the last decade, but the Reserve Bank is forecasting the dis-savings rate to deteriorate over the next two years to 0.9% and 0.8% respectively after actual savings of 1.5% in 2013/14.

"It hasn't had the improvement you've seen in many other countries, for example in Europe or Australia," Wheeler said, pointing to the bank's forecast of the current account deficit worsening to 6.1% of GDP by 2016/17 from 2.5% in the 2013/14 year.

Here is the full statement from the Reserve Bank:

The Reserve Bank today increased the Official Cash Rate (OCR) by 25 basis points to 3.25 percent. New Zealand’s economic expansion has considerable momentum, with GDP estimated to have grown by around 4 percent in the year to June. Global financial conditions remain very accommodative and are reflected in low long-term interest rates and narrow risk spreads.

Economic growth among New Zealand’s trading partners is gradually improving and global inflation remains low. Prices for New Zealand’s export commodities remain historically high, but their recent falls will reduce farm incomes over the coming year.

A continued acceleration in construction in Canterbury, and more broadly, is supporting growth, together with strong net immigration flows that are adding to housing and household demand. Business and consumer confidence remains buoyant, as do businesses’ reported intentions to invest and to hire.

While house price inflation remains high, the housing market has moderated since late last year when restrictions were applied to high loan-to-value ratio mortgage lending and when mortgage interest rates began rising. Fiscal consolidation continues to moderate demand growth, though by less than previously assumed.

The exchange rate has not yet adjusted to weakening commodity prices, but is expected to do so. The Bank does not believe the exchange rate is sustainable at current levels. Headline inflation remains moderate and tradables inflation is expected to be low for some time.

However, above-trend growth has been absorbing spare capacity and adding pressure to non-tradables inflation. These pressures are particularly evident in construction cost increases. Nevertheless, overall wage inflation remains moderate, reflecting recent low headline inflation, increased labour force participation and strong net immigration.

Inflationary pressures are expected to increase. In this environment, it is important that inflation expectations remain contained and that interest rates return to a more neutral level. The speed and extent to which the OCR will need to rise will depend on future economic and financial data, and its implications for inflationary pressures.

By increasing the OCR as needed to keep future average inflation near the 2 percent target mid-point, the Bank is seeking to ensure that the economic expansion can be sustained.

(Updated with currency move and comments from news conference)