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ACT's The letter

GOING UP

Even though it was predicted – Michael Cullen prematurely announced it – the increase in interest rates was the big news of the week. The Reserve Bank lifted the official cash rate from 6% to 6.25% and indicated there are more interest rises to come. The Bank estimates the economy grew by 5% in the year to June. The Letter believes growth may be closer to 6%. The Bank believes the economy is growing at 1.75% above its “potential output”, that is above the economy’s sustainable growth capacity, and this is producing inflationary pressure. “Domestic inflation” is at 5% and only the high dollar that has kept the price of imports down has held inflation under 3%.

RECORD PRICES

Commodity prices are at record levels. The Bank makes a rosy forecast of world growth, especially China, so keeping up the demand for our exports. The Bank, while predicting strong growth, believes the economy is near its peak and in housing has peaked already. “Further ahead, economic growth is expected to slow as the effects of a cooling housing market, lower net immigration, and higher interest rates dampen household spending, while the worsening terms of trade end the lagged effects of the high exchange rate impact on the external sector.” The Bank is predicting just 2% growth next year.

THE IMPACT

The Bank notes, "Despite rising incomes, the debt to income ratio of households has increased to over 130%. Essentially, low interest rates and rising housing-related wealth have encouraged households to take on more debt, which has also been evidenced in high rates of household credit growth." The Bank believes one reason for the delayed response to its interest rises is because 68% or more borrowing is now fixed.

COMMENTARY

This is the fifth time this year the Bank has increased interest rates. Domestic inflation is now running at 5% and the Bank is predicting inflation to be close to the top of the Bank's target (2.75% expected for late 2006). Inflation is already out of the bag. The Bank has underestimated inflation this year and may still be underestimating the strength of the economy and inflationary pressure.

GOVERNMENT ROLE

Reserve Bank Governor Bollard is unwilling to criticise government policy settings. The Bank's only comment on fiscal policy was to say that government expenditure will "provide some stimulus to the domestic economy". This year's welfare budget is inflationary. The state sector is pushing up wages. It seems certain this year's health sector settlements will exceed inflation. The government's infrastructure spending is putting pressure on the construction sector. It is hard to control inflation when the government, which accounts for approximately 40% of GDP, has policies that are inflationary.

THE ECONOMY

The Bank says wages are increasing by about 4% overall and the “proportion of all firms increasing salary and ordinary time wage rates in the June quarter rose to the highest level in the history of the series." Wage inflation is already underway. At some point the higher interest rates will kick in but if it does so at the time the terms of trade change, the economy may be in for a hard rather than soft landing. Interest rate changes impact for up to 18 months. So if the Bank is right and the economy is going to slow next year, last week’s rate increase may not only be unnecessary but may add to the slow down.

STRUCTURAL WEAKNESS

We may be witnessing a limitation in our monetary policy. NZ was one of the first nations to grant the central bank independence and the sole task of monetary stability. It has resulted in very low inflation. Government now believes that inflation is not its problem. With lower government debt and higher tax revenue from inflation the government has no incentive to ensure its fiscal policy is not inflationary. So we are seeing the private sector and the housing industry very hard hit as the only sector available to the Bank to put pressure on. Once again it is middle NZ that received nothing in the Budget that is paying the extra taxes though inflation and now extra mortgage interest rates.

POLITICS

So election year mortgage interest rates will be rising and the economy will be slowing. The mortgage belt electorates of Auckland are very sensitive to interest rate changes. The huge increase in household indebtedness means interest rate rises are going to cause real distress to many families who are already stretched.

VERY VULNERABLE

The unanticipated increase in commodity prices shows again how vulnerable NZ is to external shocks. The news last week that a Thai man died of Chicken flu (the Thai’s thought they had stamped it out in May) shows that another SARS like epidemic could strike at any time. With tourism now our biggest export earner the external vulnerability has increased.

THE POLLS

TV one is the latest poll; National and Labour on 42%, NZ first 5%, Greens 4%, ACT 3% and Maori and United on 2% is a very interesting result. Governments traditionally lose ground during the campaign. (Labour lost a massive 10% last election). The third parties have picked up support in election campaigns. (ACT has in every election polled double its average pre-election support.) The Maori party seems on track to win the 7 Maori seats and hold the balance of power – scary. Such a prospect may cause a swing to National. The next election is wide open.

THIS WEEK’S POLL

Last week 64% of people thought it was an abuse to name a crime victim under Parliamentary Privilege. This week "Should the Reserve Bank have increased interest rates?" http://www.act.org.nz/poll - We will send your answer to the Reserve Bank.

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