RBNZ Observer: On hold this week but rates need to rise soon

RBNZ Observer: On hold this week, but rates need to rise soon

The RBNZ Observer: On hold this week, but rates need to rise soon On hold this week 4 Global concerns will once again prevent hikes next week... 4... but high inflation and the solid upswing mean tighter policy will be needed soon... 4... we still expect a hike by year-end, though global risks could keep them on hold for longer

Keeping your eye on the ball

With the All Blacks winning the Rugby World Cup final this weekend, it is clear the All Blacks have kept their eye on the ball, it is certainly worth asking whether the RBNZ is still on the ball.

This week has provided some key information in this regard in the form of the Q3 CPI. The CPI rose by 0.4% in Q3 and 4.6% y-o-y, which will provide some comfort for the RBNZ as it may give them a bit more wriggle room.

But for policy the key factor is the inflation outlook. In our view, New Zealand’s growth prospects are still strong and inflation is starting the upswing at an already elevated level, so the policy prescription seems clear: rates need to rise, and soon.

On domestic grounds we would expect that the RBNZ would have already lifted rates. But we expect heightened global risks will once again keep the RBNZ on hold this week. On the international risks, the key challenge for the RBNZ is to assess the extent to which weaker growth in the West could take the shine off the expected domestic recovery.

In our view, a significant part of the expected pick up is ‘baked in’, so to speak, so a recovery seems more likely than otherwise. In particular, the economy will be supported by post-earthquake reconstruction of Canterbury (worth a very large 10% of GDP). Relative to the size of the economy, New Zealand’s reconstruction spending is larger than the reconstruction efforts in Japan due to its earthquake (around 3-4% of GDP).

The other factor that is expected to support growth is the high level of dairy and meat prices. This is the trickier part of the story. If Asia manages to grow solidly through the coming period, despite the Western slowdown (which is our central forecast) it seems likely that dairy and meat prices will stay high – which is another reason to hike soon. However, we expect that the risk that commodity prices fall, as they did back in 2008, will be a factor keeping the RBNZ on hold, as will concerns about potential bank funding costs, given banks exposure to international markets. Domestic recovery expected and inflation elevated To some degree, the expected upswing in New Zealand’s economy will be driven by factors that are not likely to be sensitive to the world situation. This includes the reconstruction of Canterbury and, of course, the boost from the Rugby World Cup. The high level of commodity prices is more questionable, though our view is that prices will remain elevated as long as Asia manages to pull through with solid growth.

Canterbury’s reconstruction is expected to drive a substantial pick-up in investment over the next two years, and there are early signs that this has gotten started, after significant delays. It is also worth keeping in mind that this is pre-funded and because it is repair and reconstruction is presumably far less susceptible to cancellation than other types of investments. The total value of reconstruction is estimated to be around NZD20bn, which is equivalent to around 10% of GDP.

The upswing is also expected to be supported in the short run by expenditure during the Rugby World Cup, which has just come to a close. We expect this to have boosted the economy by around 0.3-0.5% of annual GDP in the second half of this year.

The other factor that is expected to continue to support the economy is the high level of commodity prices. Meat and dairy prices remain around 70% higher than they were in mid-2009. While dairy prices have eased a bit recently, this largely reflects seasonality, with recent auctions showing further support for dairy prices. Meat and dairy prices have been supported by continued demand from Asia. Much of this demand is expected to continue, even in the face of a modest slowdown as it is driven by the burgeoning Asian middle class, particularly in China.

The experiences in late 2008 and early 2009 when dairy prices fell sharply will, however, be fresh in the minds of policymakers and businesses. In response to the run-up in dairy prices in 2006 and 2007, dairy farmers took on debt and made substantial investments, only to be burned when commodity prices fell as a result of the global financial crisis. After a period of deleveraging, the rural sector is ripe for further investment – and there are some signs that this has gotten started. While there is a chance that the recent global financial ructions delay some of these investment plans, business confidence indicators generally remain positive so far.

On this outlook alone it seems reasonable that rates should be lifted from their current emergency lows.

Add to this that inflation is already at elevated levels and the case seems fairly clear, in our view.

Part of the strength of the argument for rate hikes rests in the fact that rates are at exceptionally low levels, particularly in real terms. We believe this is unsustainable in the medium term and risks boosting inflation if left low for too long. These are all key reasons why Governor Bollard once again reminded us that with rates at emergency lows we should expect that they will need to rise at some point.

While we boldly suggest that this point should be sooner rather than later, we expect that the current level of heightened global uncertainty will keep rates on hold this week.

With the RBNZ seemingly close to pulling the trigger, much depends on the global situation.

Bottom line We expect global uncertainties to keep rates on hold this week. On domestic conditions alone we think the RBNZ should be lifting rates, and we still expect it to take back part of the emergency cut by year-end.

But the clear downside risk to this outlook comes from the global economy and financial developments in Europe in particular.

Paul Bloxham, Chief Economist (Australia and New Zealand) HSBC Global Research Economics - Data Reactions 26 October 2011

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