RBNZ lifts OCR as expected, but says future rate hikes to be less extensive (Update 4)

The Reserve Bank of New Zealand has announced a 25 basis point increase in the Official Cash Rate to 2.75%, its first hike in almost 3 years and its first move of any kind in over a year.

(Updated with ASB comment about the OCR rising to 5%, wholesale interest rates rising after the decision, BNZ seeing the OCR rising eventually to 6%, NZMEA saying hike is reckless, Westpac seeing OCR rising to 6% and commenting on relatively hawkish tone)

Reserve Bank Governor Alan Bollard argued strong export revenues and growth in New Zealand’s major trading partners would help make the economic recovery become self sustaining. He repeated his arguments from last month when he said it was time to take the foot off accelerator and lift the OCR from its record level of 2.5%.

The result was expected by economists and is likely to trigger an increase in floating mortgage rates by banks. A 0.25% increase in the floating mortgage rate on a NZ$200,000 mortgage would increase interest costs by around NZ$10 a week.

Bollard said that future OCR hikes were likely to be less severe than in previous tightening cycles because more borrowers were on floating rates, bank funding costs had increased and floating rates were cheaper than fixed rates. However, Bollard warned that further financial market turmoil could change the Reserve Bank’s view, as would any resumption of strong consumer spending and household lending.

My view

Alan Bollard has done the right thing, despite the calls from some exporters for more relief and the less than remote prospect of a financial market meltdown in Europe. The prospect of inflation rising to 5.4% by midway through next year and leaving the Official Cash Rate at a record low of 2.5% is unthinkable. Even though much of the spike is one off in nature (GST increase, ACC levies hiked and ETS costs imposed), Bollard is right to point out that a surge in export incomes and GDP growth of 3.5% each year for the next couple of years will take plenty of slack out of the economy and increase price pressures.

Bollard is also getting plenty of help from friends, but they are not the usual friends in government. This time the financial markets have pushed up longer term funding costs for the banks and the banks themselves are choosing (or being forced) to raise more funding from expensive local term deposits. This means Bollard can afford to increase the OCR more slowly and not to such a high level as in the past. This time around the RBNZ expects the 90 day bank bill rate to peak at around 6.1% in late 2012, up from around 2.9% now.

That would, in theory, increase floating mortgage rates from around 5.8% now to around 9% by then. Term deposit rates are also likely to rise by as much if not more as the banks come under increasing pressure to raise funds locally. The margin between retail term deposits and wholesale interest rates has risen in the last two years from around 50 basis points below wholesale rates to as much as 200 basis points above wholesale rates.

That would imply term deposit rates rise to well over 6% by the end of 2012. All this will continue to exert downward pressure on house prices, as the Reserve Bank forecast in its June quarter monetary policy statement. It has reduced its forecasts for house prices by around 2% from its March quarter forecast and now expects nominal house prices to only just recover their price fall.

Your view?

ASB economist Jane Turner said the increase was widely expected. Her comments are here:

The OCR increase and the RBNZ’s accompanying statement held few surprises. As is the case with all RBNZ decisions, each and every one is always conditional on events leading up to it. Europe remains the main event risk that could make the RBNZ pause at some point in the near term. We continue to expect the RBNZ will lift the OCR by 25bp at each meeting until the OCR reaches 5%. Although our expectation is lower than that implied by the RBNZ’s forecasts (near 6%), it is still higher than market pricing for the end point.

Given the event risk posed by Europe, pricing in some risk of a pause in the tightening cycle is warranted - and has been the reality in Australia where meetings are more frequent. Nevertheless, there is still scope for market expectations of the peak OCR to increase when the risk environment is calmer.

The market reacted to the announcement with interest rates and NZD higher. NZD-USD is 50 points stronger trading at 0.6710 with NZD-AUD also 50 point stronger at 0.8110. Short term interest rates have increased, with the 1-year swap rate lifting around 8 basis points. Longer term rates have lifted more modestly, by 4-6 basis points.

BNZ economist Stephen Toplis said the OCR could eventually rise to a peak of 6%. His comments are here.

After twelve months of stagnation, at a very low level, the RBNZ has finally deemed it time to start pushing the cash rate higher. This morning it was raised to 2.75% from 2.50% in what is expected to be the first move in a series, which will eventually see the rate push up, first, to neutral and then, probably, a little to the tighter side of such.

At face value, it appears the Bank intends raising the cash rate 25 basis points in each of its next six meetings taking it to 4.25% by March 2011. Thereafter, it looks as if the Bank intends the odd pause or two but progressing until the cash rate peaks at around 5.75 to 6.00%. Note that, at least in the first instance, the RBNZ does not see these increases as being in anyway contractionary but rather as a removal of stimulus or a reduction in the pressure on the accelerator. This may appear a pedantic difference but it does explain why the Bank has moved and why it will move again, despite the economy remaining in a vulnerable state.

For all intents and purposes the RBNZ’s interest rate projections sit bang in line with our own. Importantly, to start with, we believe a further 25 point increase is highly likely at the next meeting on 29 July.

At this stage we would put a probability of 80% on this. Be that as it may, it is important to recognise that we are in very volatile times so the Bank will have to be extremely flexible for some time.

The Bank again reiterated that the combination of the increased proportion of floating rate debt in the banking system, the steep upwardly-sloped yield curve, and heightened bank funding margins means that rates may not need to be raised as aggressively this time around. This is so but borrowers should also be warned that at the peak in this cycle the RBNZ’s cash rate may be substantially lower than normal but lending rates may not be so because of the increased margin between what the banking system is now funding itself at and the official cash rate as set by the RBNZ.

The financial market response to today’s announcement was relatively muted. Fixed interest markets sold off very modestly across the curve, predominantly reflecting the fact that today’s hike was not fully priced in rather than any change in view about the future track in interest rates. Incidentally, current market pricing remains less aggressive than the RBNZ’s view as markets, currently, are being driven more by nervousness about international developments than happenings closer to home. T

The NZD did, nonetheless, bounce around 70 basis points against the USD and by a similar margin against the AUD as the likely improvement in New Zealand’s interest rate differential was today confirmed.

Westpac economists said the tone of the RBNZ's statement was more hawkish than expected and signalled a rise in the OCR slightly quicker than some had expected. Here are their comments below.

The RBNZ has been signalling for a long time that interest rates would need to start rising once the economy stabilised, and today it delivered, increasing the Official Cash Rate by 25 basis points to 2.75%. The RBNZ also made it clear that more will need to be done. There was even, dare we say it, a hint of urgency to get on top of medium-term inflation pressures while they have the opportunity. While the market was largely in agreement about today's move, the question on everyone's mind was what signal the RBNZ would give on future hikes.

That question become even more intriguing after last week's statement by the Bank of Canada, a central bank that is seen as having much in common with the RBNZ. The BoC was extremely noncommittal on further hikes, noting that super-low interest rates were still appropriate (their cash rate is just 0.5%) and that any further moves would be at the mercy of global and domestic developments. In contrast, the RBNZ's statement made it clear that this should be seen as the first step in an extended series of rate hikes: "we have decided to begin removing some of the monetary policy stimulus that is currently in place".

The debate from here on will be around when and how much: "The further removal of stimulus will be reviewed in light of economic and financial market developments". In any case, the RBNZ doesn't have the scope to be so coy about future moves, since it regularly publishes a projection for 90-day interest rates that is consistent with the economic outlook (a practice that was once unique but is becoming more accepted among central banks). That projection is not a firm commitment, but it is meant to be a powerful tool for signalling the RBNZ's intentions.

The last projection in March showed the cash rate returning to a 'neutral' level of 5.5-6.0% over the next few years - and even that would only just have been enough to keep medium-term inflation contained within the upper edge of the 1-3% target band .

Today's statement indicates that the RBNZ now expects to move toward that end-point even faster. The 90-day rate is expected to reach 5.3% by the end of 2011, compared to 5.0% in the March forecasts. That's not quite consistent with a 25bp hike at every review date for the next couple of years - but it's not far off. The case for rate hikes is twofold. First, the RBNZ is now confident that the economy is normalising, which implies that monetary policy settings should do the same. There's an element of rebalancing going on, so the recovery isn't being felt in all parts of the economy: household spending and credit growth are still subdued, and firms' stated intentions to increase investment are not yet being acted upon.

But on the plus side, the growth outlook for our major trading partners has continued to improve, and export commodity prices have reached new highs. This boost to export earnings is expected to eventually flow through to income growth in other parts of the economy. The market was perhaps surprised by the RBNZ's relative comfort about the recent financial market ructions related to Europe's sovereign debt woes - though it had said as much in the Financial Stability Report last month.

While the RBNZ highlighted this as a substantial downside risk, the only impact on its central projections was in terms of the 'knowns': a downward revision to already-weak growth forecasts for Europe, and a rise in bank funding costs that the RBNZ assumes will be sustained.

RBNZ staff mentioned that they did consider producing an alternative scenario, where the European situation became graver. But it would have required a complex set of assumptions, and although the direct effects for the world might be obvious, the net impact on New Zealand might actually be ambiguous. (One example that's already apparent: the turmoil has encouraged the US Federal Reserve to keep policy loose for longer.

That in turn means looser conditions in the fast-growing East Asian economies, many of whom effectively import their monetary policy settings from the US. And Asia's strong growth is a crucial factor behind the strength in New Zealand's exports and terms of trade.) The other reason for raising rates now is the inflation outlook. The RBNZ was faced with a tricky challenge this time: a barrage of one-off price increases, where the direct effects could be looked through, but a risk that they could feed into wage- and price-setting behaviour over the medium term.

Once inflation expectations become embedded they can be difficult to squeeze out, and the RBNZ's own survey indicates that medium-term inflation expectations have already risen back towards the upper end of the 1-3% target range. Recent government policies - the GST increase, the Emissions Trading Scheme, and several rounds of tobacco excise hikes - will add 2.8 percentage points to the inflation rate at their peak early next year. As a consequence, the RBNZ expects annual inflation to reach 5.3% in June 2011, then moderate to around 2.7% in the latter years of their forecasts.

The RBNZ is assuming that these price increases will have a limited impact on longer-term inflation expectations - in particular, the GST hike is expected to have no impact on wage bargaining since it will be more than offset by income tax cuts. But the message implicit in the RBNZ's projections is somewhat different. The forecast for underlying inflation (that is, excluding the direct impact of the policy-induced price hikes) is slightly lower than in March, peaking at 2.6% next year rather than 2.8%.

Indeed, consider the broader picture: the interest rate projection is steeper for the next year, the exchange rate projection is 2-3% higher, and offshore funding costs are higher - all up, a substantially tighter mix of financial conditions compared to March. Meanwhile, there was a downward revision to their GDP growth forecasts, and a lower track for underlying inflation.

There seems to have been a conscious choice to target a lower level of (underlying) inflation over the medium term. That may well prove to be a prudent decision - the RBNZ is effectively bracing for the possibility that its assumption about inflation expectations is proven wrong.

Market implications

Today's rate hike was not fully factored into financial markets, as the situation in Europe had created some uncertainty. The two-year swap rate rose by 5bps, and the NZ dollar has risen almost a cent to 0.6760. The initial reaction in the currency shouldn't be read as a sign of things to come - in the current market volatility, 1-2c daily moves in the exchange rate are proving to be common, and easily reversed.

The statement was consistent with our forecast of a 25bp OCR hike at each review date, reaching a peak of 6% in early 2012. There's highly likely to be some variation around this - there could be some pauses, there could be some larger 50bp moves, but at this stage there's little value in trying to precisely predict every move.

The RBNZ has a general plan to return the policy rate to 'normal' as the economy gets back on its feet, and 'normal' is considered to be substantially north of 2.75%.

NZ Manufacturing and Exporters Association CEO John Walley described the rate hike as reckless. Here are his comments:

We do not share the optimism from the Reserve Bank on the rate of recovery. Currently the main drivers of the projected inflation rate are a GST rise, an increased tobacco tax and the Emissions Trading Scheme. These one off factors should not trigger an OCR rise.

Business confidence surveys have indicated that expectations have improved but real measures of sales, investment and employment tell, at best, a weak recovery story.

This combined with the risks posed by financial instability in Europe, a sluggish recovery in the United States and higher risks in Australia make the OCR decision difficult to appreciate. We have already seen the dollar climb after the decision and this could do some major damage to any rebalancing of the economy.

Here is the full statement below from the Reserve Bank.

The Reserve Bank today increased the Official Cash Rate (OCR) by 25 basis points to 2.75%.

Reserve Bank Governor Alan Bollard said: “The economy has entered its second year of recovery with growth becoming more broad-based.” “The recovery in trading partner activity is continuing, with growth in Asia particularly strong. Along with ongoing growth in Australia and recovery in the United States, this has so far offset weak growth in some other export markets. Against this back drop, New Zealand’s export commodity prices have increased sharply over the past few months, boosting export incomes.”

“In contrast to signs of global economic recovery there has been renewed turmoil in financial markets. Currently, we expect the main impact on New Zealand to come through continuing upward pressure on the cost of funds to the banking system

“In New Zealand, growth of around 3.5% is expected this year and next. The main drivers of this outlook are higher export prices and volume growth, an improving labour market and a pick-up in residential and business investment. However, we expect households to remain relatively cautious, with the housing market and credit growth staying subdued. This moderate household spending contributes to some rebalancing in the economy.

“Underlying CPI inflation is expected to track within the target range even as the economy expands further. That said, headline CPI inflation will be boosted temporarily by the announced increase in GST and other government related price changes. Provided households and firms do not reflect this price spike in their wage and price setting behaviours, we do not expect a lasting impact on inflation.”

“Given this outlook, and as previously signaled, we have decided to begin removing some of the monetary policy stimulus that is currently in place. The further removal of stimulus will be reviewed in light of economic and financial market developments. “The fact that bank funding costs are higher, long term interest rates are higher than short term interest rates, and a greater proportion of borrowers use floating rate mortgages should all reduce the extent to which the OCR will need to be increased relative to previous cycles.”