The RBNZ Observer: 26 July 2011

26 July 2011
For Immediate Release

The RBNZ Observer

On hold this week, but expect hawkish commentary, says HSBC

•Growth is rising, inflation is high, and rates are at emergency lows ...
• we have long thought the March rate cut was a mistake and expect a reversal soon
• but not this week, given global uncertainties and RBNZ’s cautious approach; next hike Q4, with risk of earlier move

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On hold this week, but hikes due soon

Six weeks ago the Governor shifted the rhetoric from rates will be on hold for ‘some time’ to rates will be on hold ‘for now’. At the time, we posed the question: what will another six weeks bring? The answer: further confirmation that a solid recovery is underway and that inflation is uncomfortably high, particularly for the beginning of an upswing.

GDP has risen solidly for two consecutive quarters: GDP was almost 1% higher in Q1 than the RBNZ expected (accounting for revisions). Headline inflation is at its highest level since inflation targeting began and has been above the target band in quarterly terms for four consecutive quarters. Inflation expectations have also risen to the top of the band.

We have long held that the March cut was a mistake and that cutting rates was the wrong response to a negative supply shock (RBNZ Observer, 8 March 2011). At the time we misjudged the RBNZ, thinking that they too would see monetary policy as the wrong tool, and hold steady. We are now at another critical juncture where our judgement is that rates need to rise, and soon, but the question is: does the RBNZ agree with this prognosis? We think the RBNZ will hold rates steady this week, but provide a more hawkish tone in their commentary. We still expect the next hike in Q4, but the risk is for a September move.

Recovery in swing

Growth in the New Zealand economy picked up around the turn of the year and by significantly more than the RBNZ (and markets) had expected.

GDP rose by a strong +0.8% in Q1 and was revised up to +0.5% (from +0.2%) in Q4 2010: RBNZ forecasts were for +0.3% in Q1 (the market consensus was the same). So the level of GDP is almost 1% higher than the RBNZ had expected it to be as at the last official statement.

We expect growth to continue. While the Canterbury earthquake – which occurred in late February – continued to disrupt activity in Q2, such that growth probably slowed, we still expect a solid +0.5% rise in Q2. Timely indicators suggest that the bulk of the economy continued on the recovery path, despite the February earthquake. We also need to keep in mind that the Canterbury region is only 15% of the economy, two-thirds of which is dairy and meat production, which was largely unaffected by the quake.

Strong growth is then expected in H2, supported by high dairy and meat prices, the Rugby World Cup and rebuilding of Canterbury. We expect the Rugby World Cup to add 0.3-0.5pp to the economy and for high agricultural prices to drive a pick up in rural investment. The rebuilding of Canterbury will be boosted by significant fiscal support, including from the earthquake reconstruction fund. Timely surveys of business conditions and confidence are at levels consistent with solid growth in H2. The labour market has been improving, with strong employment growth in Q1 and a significant increase in participation.

Working against this story of improving conditions has been the continued weak performance of the housing market. This has been a key concern of the RBNZ. Housing prices have tracked broadly sideways for four years and were flat over the past year, reflecting that households are continuing to de-leverage. This is despite the fact that the RBNZ has reduced interest rates to emergency lows. Despite this, household consumption has continued to grow, at around 1½ per cent over the past year, with recent data on retail card spending suggesting it will continue.

Importantly, the economy is expected to be driven by exports, rural investment and rebuilding over the coming period, rather than the housing, and the de-leveraging process may still take some time. This is an argument for below average rates, but not emergency low rates.

Rates very low, but exchange rate is doing some work
With inflation running at well above the RBNZ’s target and the cash rate at emergency low levels, real interest rates in New Zealand are at exceptionally low levels.

Even abstracting from the impact of the tax changes on the headline CPI measure – Statistics NZ has told us that excluding the tax effect, inflation was running at 3.3% – still delivers a real interest rate that is negative. Using current estimates of inflation expectations – which the RBNZ measure suggests are 3.0% on a two year forward looking basis – also delivers a negative real cash rate.

It seems no matter how you cut it, real interest rates are at very low levels.

Working in the opposite direction is the recent strength of the exchange rate. In recent weeks, the NZD has hit new highs against the USD and is around pre-GFC highs against a trade-weighted basket, which will be providing a dampening influence for the traded sector and inflation.

Two factors offset this though. The first is that part of the strength in the NZD is likely to reflect the high level of rural commodity prices, so while income is being boosted by the commodity prices, the exchange rate is doing some of the adjustment in terms of tempering that income flow. The other issue is that the NZD is still low against the AUD when compared with history. This is important because Australia is New Zealand’s largest trading partner. And given the solid outlook for growth in Australia, the competitive NZD/AUD cross rate will be providing some support for the economy.

Global risks front and centre
If it were not for the current developed world sovereign debt developments – which are still front and centre in financial markets – we suspect there would be a fairly good case for the RBNZ to be lifting rates this week. As we have argued above, domestic conditions seem to warrant it. The market currently has a very low 8% chance of a hike this week, probably reflecting global concerns rather than domestic developments.

We suspect that with the US ‘debt ceiling’ issue still hanging in the balance and European debt worries continuing, the uncertainties associated with these developments will keep the RBNZ on hold. However, we do expect the rhetoric to be significantly more hawkish than at the previous announcement.

Bottom line

The New Zealand economy is recovering and inflation and inflation expectations are currently at uncomfortably high levels.

We think domestic conditions warrant a reversal of emergency monetary policy settings, but expect the RBNZ to remain on hold this week due to global uncertainties and a generally cautious approach to monetary policy.

We expect the next rate rise in Q4, though think there is a tangible risk of an earlier move, and still expect that rates will rise by a total of 175bps by end 2012.

ENDS

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