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Reserve Bank Sets Out Aggressive Track For Rate Rises

Reserve Bank Sets Out Aggressive Track For Interest Rate Rises

Strong Growth Increase Inflationary Pressure

9:30am, 13 March 2014

The Reserve Bank has kicked off a series of interest rate rises, ending a 3-year run when the official cash rate stood at a record low of 2.5%, as the NZ economy outperforms its peers.

RBNZ Governor Graeme Wheeler is seeking to curb inflationary pressure building strongly as the economy speeds up, looking as if it could grow at an annual rate of 3.5% to 4%.

Wheeler, saying inflation pressures are building, lifted the OCR to 2.75% and outlined a relatively aggressive track ahead, with the OCR likely to reach 3.75% by the end of this year and 4.75% by the end of next.

NZ Moves First - NZ is the first developed country to move away from the easy money conditions which have prevailed since the global financial crisis erupted 5 years ago.

Wheeler is responding to NZ growing faster than the bank believes is sustainable without inflationary pressures outrunning its targeted limits.

Inflationary Pressure Building - Wheeler says while headline inflation has been moderate, inflationary pressures are increasing and are expected to continue doing so over the next 2 years. “The speed and extent to which the OCR will be raised will depend on economic data and our continuing assessment of emerging inflationary pressures.” The RBNZ sees a faster pace of inflation than in its December forecast, with the consumers price index rising to 2% as soon as the June quarter, a level the bank had previously expected in mid-2015. While a strong currency will keep a lid on imported inflation, the bank expects non-tradable inflation to increase to about 4%.

Significant Rise - The monetary policy statement said the bank expects “the OCR will need to rise by about 2 percentage points over the next two years for inflation to settle around the target,” depending on the economic outlook. Wheeler says “by increasing the OCR as needed to keep future average inflation near the 2% target mid-point, the bank is seeking to ensure that the economic expansion can be sustained.” He’s tasked with keeping CPI between a range of 1 and 3%, with a target to keep inflation near the mid-point.

Higher Housing Costs - For households, the rise in the interest rate means higher housing costs, particularly for those with floating rate mortgages. If rates rise by 1 percentage point by the end of this year, it will add another $20 a week for each $100,000 they borrowed. So a family with a $300,000 mortgage will face an extra $60 a week by the end of this year. Some economists are picking the OCR will rise by 150 to 200 basis points over the next 18 months. In NZ, total private debt is calculated to be around $180bn, with dairy industry debt estimated to be around $50bn. But if rate rises are bad news for business and households, they are good news for savers. It’s estimated about $120bn sits in bank deposits and other institutions.

Growth Sustainable Despite Business Concerns - Tightening monetary conditions is intended to take some of the stimulus out of the economy. Business leaders worry it may halt or even reverse the upswing. But the Reserve Bank believes NZ’s sustainable growth capacity is in the range of 2 to 3%. With growth accelerating to around 4%, it’s time to apply the brakes. Floating mortgage rates are now about 5.75% but could rise to around 7.5 % to 8% in the next couple of years.

With the Reserve Bank having signalled the prospect of interest rate rises, many households have weighted their borrowing to fixed-rate terms. For some time economists have been contending monetary policy settings are looking increasingly out of whack with the economic outlook, and predicting the monetary policy statement this week would launch the journey to policy normalisation. Financial markets have been so

convinced the Reserve Bank would reverse its stimulatory stance to a more neutral track they have factored in the rate rises. On Wednesday the trade-weighted index rose as high as 79.68, and the kiwi dollar traded at 84.64 US cents.

Exchange Rate A Problem - Wheeler says the high exchange rate remains a headwind to the tradables sector. “The bank does not believe the current level of the exchange rate is sustainable in the long run.” He believes local economic growth has considerable momentum, underpinned by strong export commodity prices and construction activity, and is becoming more broad-based. Growth has been buoyed by insatiable Chinese demand for NZ dairy products, making the world’s most populous nation the nation’s biggest trading partner, and keeping the terms of trade at a 40-year high. The bank thinks GDP grew at a 3.3% pace in the year ending March 31, and forecasts growth of 3.2% the following year, up from a previous forecast of 2.7%. Growth is forecast to moderate to 2.2% in the years to March 2016 and 2017.

Exporters Will Feel The Pain - The impact of an increase in the official cash rate by the Reserve Bank on the exchange rate will be a concern to business. At around 79 on the TWI, the exchange rate is about 2% higher than the 77.4 assumed for the quarter in the RBNZ’s monetary policy statement in December. This week the ASB Bank said about 70% of businesses surveyed by the bank expect the NZ dollar to reach parity with the Aust dollar over the coming year, but respondents also expect the NZ/US dollar cross rate to ease from current levels of 84.8USc to around 78.2USc by March 2015.

While exporters are suffering from the high exchange rate, the manufacturing sector has continued to thrive, taking advantage of the exchange rate to reinvest in machinery, and getting the benefit of lower costs for imported raw materials. Total manufacturing sales volume had a record rise in the December 2013 quarter. After adjusting for seasonal effects, the volume of total manufacturing sales rose 5.7%, with meat and dairy product manufacturing sales up 15%.

Is An OCR Rise Necessary? - Some authorities question why the Reserve Bank is raising interest rates when housing prices are coming off the boil. Data is confirming the high- LVR lending restrictions and pending rises in mortgage interest rates are constraining demand. Housing approvals remain well below where they were a year ago, further confirmation that housing market activity is unlikely to bounce back quickly.

Impacting On Election Prospects - So how will tightening monetary policy, if it curbs the economic upswing, affect the “feel-good” factor which the Key-led coalition is relying on to win re-election? Political opponents have been quick to argue the effort to slow the pace of economic activity means the Govt will not hit its job growth targets. But National sees some positives in the return to normality in monetary conditions. The potential for another damaging housing price bubble has been de-risked. Over the past 5 years corporates have regained stability in their balance sheets. National wants to ensure economic expansion is sustained. So it’s on the same song sheet as the RBNZ Governor who says in containing inflation expectations he is seeking to keep NZ growing in a balanced way.

The aggressive track set out for interest rate rises is sure to re-ignite debate about monetary policy (and it it’s only a question of which out of Winston Peters, David Parker or Russel Norman will be first on the starting blocks to do so). Central bankers around the globe are faced with extraordinary challenges in the aftermath of the global financial crisis.

Wheeler has stepped up to the plate.

The Main Report Editors
Max Bowden
Ian Templeton
Tony Doe

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