RBNZ holds OCR, but increases forecast interest rate track 50 bps; says LVR limit equal to 30 bps of hikes

By Bernard Hickey

The Reserve Bank of New Zealand has held the Official Cash Rate as expected at 2.5%, but has increased its forecast track for interest rates by around 50 basis points as it sees inflation pressures building from the Canterbury recovery and the Auckland house price surge.

It now sees short term interest rates rising around 200 basis points to 4.7% through the two years from mid 2014.

This would imply floating mortgage rates rise to around 7.5% by early 2016 and suggests interest rates would rise around 100 basis points by the end of 2014 as next election approaches.

The central bank warned again that house price and construction cost inflation could spill over into wider inflation pressures and it was likely to increase the OCR next year. Its forecasts for the 90 day bill rate suggest it has bought forward its first expected rate hike from the September quarter of 2014 to the June quarter.

This remains less hawkish than market expectations for the first hike being in the March quarter of 2014 and for rate hikes over the next 3 years of 200 to 300 basis points.

However, markets viewed the statement as slightly more 'hawkish' on interest rates and pushed the New Zealand dollar up by more than half a cent to near a one-month high of 81.4 USc. The two year wholesale swap rate rose 2 basis points to 3.52%.

The bank also estimated that the limits on high Loan to Value Ratio (LVR) lending it is imposing from October 1 were 'worth' around 30 basis points of interest rate increases. This implies the Reserve Bank would have increased its forecast track by around 80 basis points with a peak closer to 5% by early 2016 than the 4.7% currently forecast.

What the Reserve Bank said today compared with last time

Here is a section- by- section parsing of the Reserve Bank's statement today in comparison with its last statement on July 25 to see how its view has changed. The July 25 comments are indented.

September 12 - The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 2.5 percent. Reserve Bank Governor Graeme Wheeler said: “The global outlook remains mixed. GDP growth in Australia and China has slowed and some emerging market currencies have come under considerable downward pressure. At the same time, the major developed economies continue to recover and New Zealand’s export commodity prices remain very high.

“Although long-term interest rates have risen globally in recent months, largely due to uncertainty around the timing of the Federal Reserve’s exit from quantitative easing, global financial conditions overall continue to be very accommodating.

July 25 - The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 2.5 percent. Reserve Bank Governor Graeme Wheeler said: “The global outlook remains mixed, with the euro area still in recession and signs of slower growth in China and Australia, but more positive recent indicators in the United States and Japan. Global debt markets have become more cautious due to uncertainty around the Federal Reserve’s anticipated exit from quantitative easing. The key difference is the comment about New Zealand's commodity export prices remaining very high. The bank also chose to point out global financial conditions were very accommodating, referring later in the monetary policy statement to how bank funding costs on wholesale markets were relatively low.

September 12 - “In New Zealand, GDP is estimated to have increased by 3 percent in the year to the September quarter. Consumption is rising and reconstruction in Canterbury will be reinforced by a broader national recovery in construction activity, particularly in Auckland. This will support aggregate activity and start to ease the housing shortage.

July 25 - “Growth in the New Zealand economy is picking up and, although uneven, is becoming more widespread across sectors. Consumption is increasing and reconstruction in Canterbury will be reinforced by a broader national recovery in construction activity, particularly in Auckland. This will support aggregate activity and eventually help to ease the housing shortage. The main change is the Reserve Bank has lifted its forecast for GDP growth.

Sept 12 - “In the meantime rapid house price inflation persists in Auckland and Canterbury. As has been noted for some time, the Reserve Bank does not want to see financial or price stability compromised by continued high house price inflation. Restrictions on high loan-to-value residential mortgage lending, which will come into effect next month, are expected to help slow the national housing market.

July 25 - “In the meantime rapid house price inflation persists in Auckland and Canterbury. As previously noted, the Reserve Bank does not want to see financial or price stability compromised by housing demand getting too far ahead of the supply response. The main difference is the Reserve Bank mentioned its high LVR speed limit and later in the statement estimated it was worth around 30 basis points worth of 'non-increases' in short term interest rates.

Sept 12 - “Despite having fallen on a trade-weighted basis since May 2013, the exchange rate remains high. A lower rate would reduce head winds for the tradables sector and support export industries. Fiscal consolidation will weigh on aggregate demand over the projection horizon.

July 25 - “Despite having fallen on a trade-weighted basis since May 2013, the New Zealand dollar remains high and continues to be a head wind for the tradables sector, restricting export earnings and encouraging demand for imports. Fiscal consolidation will weigh on aggregate demand over the projection horizon. No real change in this section, although later in the statement it does say the exchange rate is "very high" rather than just high.

Sept 12 - “CPI inflation has been very low over the past year, partly reflecting the high New Zealand dollar and strong international and domestic competition. However, inflation is expected to rise towards the mid-point of the 1 to 3 percent target band as growth strengthens over the coming year.

July 25 - “CPI inflation has been very low over the past year, reflecting the high New Zealand dollar and strong international and domestic competition. However, inflation is expected to trend upwards towards the mid-point of the 1-3 percent target band as growth accelerates over the coming year. No real change here.

Sept 12 - “OCR increases will likely be required next year. The extent and timing of the rise in policy rates will depend largely on the degree to which the momentum in the housing market and construction sector spills over into broader demand and inflation pressures. We expect to keep the OCR unchanged in 2013.

July 25 statement - “The extent of the monetary policy response will depend largely on the degree to which the growing momentum in the housing market and construction sector spills over into inflation pressures. Although removal of monetary stimulus will likely be needed in the future, we expect to keep the OCR unchanged through the end of the year.” The Reserve Bank kept its guidance on there being no OCR hike in 2013. It's major addition is the line about OCR increases 'likely to be required next year."

Economist reaction:

Westpac's economists said the Reserve Bank's new stance was more realistic.

"We have long argued that rising house prices and a construction boom would eventually provoke inflation pressures and would require a substantial OCR hiking cycle, similar to the experience of past decades. It is right for the central bank to warn markets and the populace at large that a period of higher interest rates is coming," they said.

"Indeed, moving early in this manner may limit the eventual extent of OCR hikes that are required - the anticipation of future OCR hikes has caused markets to push fixed mortgage rates up, which will slow the housing market earlier than OCR hikes on their own could have."

ASB Economist Nick Tuffley said the Reserve Bank's Monetary Policy Statement was more hawkish than expected "with the economic impact of the LVR restrictions not sufficient to offset the added inflation pressures from other parts of the economy."

"We had expected the 2 factors to broadly offset each other, giving the RBNZ scope to leave its 90-day interest rate track broadly unchanged," Tuffley said. 

"We continue to expect the RBNZ to keep the OCR on hold until March 2014, gradually lifting the OCR to 4% by late 2015.  Prior to the statement, we had said the risks to our outlook would have been to an earlier or a greater extent of OCR increases.  In the wake of this statement the risks to our view remain skewed that way, though we expect the RBNZ will want to give the LVR restrictions some time for their impact to become better known," he said.

HSBC Economist Paul Bloxham said the Reserve Bank faced a strengthening domestic economy and a lower New Zealand dollar was unlikely to keep dampening inflation as much as in the past.

"As such, the RBNZ’s next move is likely to be up, and the central bank may need to lift rates around year end. The question is: when? Our central case remains that the RBNZ lifts rates in Q4 this year, though clearly the risk is for an early 2014 move, given the RBNZ’s own commentary," Bloxham said.

(Updated with NZ$ reaction, Westpac reaction, ASB reaction, HSBC reaction)