Peter Redward thinks inflation is not the threat that markets are pricing for and RBNZ front-loading is not required

By Peter Redward*

It appears almost certain that the Reserve Bank of New Zealand will raise the Official Cash Rate (OCR) by 25bp, to 2.75% when it releases its Monetary Policy Statement on the 13th of March.

However, there exists significant disagreement about the likely pace of rate hikes, particularly over the next six months.

Some argue that the Reserve Bank is behind the curve and that it needs to front-load rate hikes.

Others maintain that conditions don’t warrant an aggressive policy adjustment and that a more measured and gradual approach remains appropriate.

Reflecting this dichotomy, the Overnight Index Swap (OIS) market is pricing a significant risk-premium around both the April and July OCR Reviews, with OIS indicating that the Bank will raise the policy rate by 75bp, to 3.75%, by July.

While it is true that short-term interest rates are unusually low, with a long-term neutral level for the OCR likely to be somewhere in the region of 4.5% +/-0.5%, the current low level of the OCR primarily reflects low global interest rates and the strength of the New Zealand dollar.

Overall monetary conditions – driven by the strong Kiwi – are already quite firm.

We observe this in both the strength of our Monetary Conditions Index, which is at levels last seen in 1996-97 and 2005-07, and in the fact that inflationary pressures remain well contained.

In December, the CPI increased by just 0.1%q/q (1.6%y/y), while measures of core inflation – the trimmed mean and weighted median – increased by 0.2%q/q (1.3%y/y) and 0.3%q/q (1.3%y/y), respectively.

We expect inflation to remain low in the first quarter of 2014, with headline CPI inflation likely to increase by 0.4%q/q (1.5%y/y) in March, largely reflecting the ongoing rise in cigarette taxes. Excluding cigarettes, CPI inflation would be just 1.3%y/y.

Low inflation buys the Reserve Bank breathing space but it says very little about the path of monetary policy.

Given the pickup in growth and surging consumer and business confidence associated with our so-called “rock-star” economy, it is possible that inflation may be just around the corner.

We don’t think so.

Under the Reserve Bank’s inflation-forecast targeting framework, strength in activity matters only to the extent that it influences the pace of capacity absorption and the degree of slack in the economy. As the economy picks-up steam, unemployment falls, wage-inflationary pressures emerge and firms, faced with strong demand, find that they can pass-on their cost increases and expand margins.

This Philips curve effect is quite noticeable in New Zealand data.

With unemployment projected to decline to around 5% by the end of this year, labour costs are likely to pick-up. We project inflation in the Labour Cost Index to increase from 1.6%y/y in 2013 to around 2.5%y/y by the end of 2014.

As businesses pass-through cost increases and attempt to expand margins, non-traded goods and services inflation is set to accelerate, from 2.9%y/y at the end of 2013 to around 3.5%y/y by the end of this year. However, this projection is already factored into the Reserve Bank’s inflation forecast.

Moreover, there are potential downside risks to this projection, notably pressure on local authorities to constrain rating increases, downward pressure on communications prices in the wake of the Commerce Commission’s ruling on Chorus pricing, moderation in the pace of electricity price hikes and the eventual completion of tax hikes on cigarettes. 

Since late 2011, we have experienced deflation in the price of tradable goods and services, notably apparel, electronics, new motor vehicles, furniture, sports equipment, games and toys. Weakness in the price of tradable goods and services largely reflects weak international prices – driven by weakness in global demand conditions, technological change, and increasing investment in commodity production – coupled with a strong NZD.

While these dynamics remain intact, it’s hard to see the price of tradable goods and services rising. Unsurprisingly, the Reserve Bank expects the price of tradable goods and services to continue to decline, albeit at a moderating pace, through 2014-15. 

Bringing these dynamics together, we see scope for the Reserve Bank to adjust its inflation forecast modestly higher, from 1.5%y/y by the end of 2014 and 2.2%y/y by the end of 2015, to perhaps 1.7%y/y and 2.3%y/y, respectively.

However, this adjustment is incremental and suggests little need for the Bank to alter its current policy stance.

To us, the key risk is the New Zealand dollar, which remains close to 50-year highs on a real effective basis.

Should New Zealand’s cyclical out-performance dissipate, driven for instance by a decline in commodity prices, a weaker currency may trigger a pick-up in tradable goods and services inflation, although even here, it’s not entirely clear how strong its effect would be as it would most likely be accompanied by declining international food and energy prices and weaker domestic demand conditions.

We conclude that the most likely outcome, for now at least, is for the Reserve Bank to hike the Official Cash Rate in a measured and gradual fashion. Consistent with the Reserve Bank’s December Monetary Policy Statement and various comments by Governor Wheeler, we look for the Bank to hike the OCR by 25bp at each of the Bank’s Monetary Policy Statements this year and next, bringing the OCR up to 4.5% by end-2015.

In our opinion, there is little need for the Reserve Bank to front-load OCR hikes and we believe that short-dated OIS yields are too high.

--------------------------------------------------------------------------------------

Peter Redward is the principal at Redward Associates, a research firm with a specialist focus in Emerging Asian foreign exchange markets. You can contact him here.