'Encouraging' rise in business confidence survey. But 'brace yourself' for OCR rises, says the National Bank

Business confidence in New Zealand improved in in July as more firms became confident their own activity would improve over the next year, according to the latest National Bank Business Outlook survey.

The result appeared to confuse markets, with New Zealand dollar falling from 87.3 US cents before the release by about 30 basis points before rocketing up to as high as 87.62 US cents - a new post-float high - before settling around 87.3 USc again after 2pm.

Here is the National Bank's business confidence report for July:

A net 48% of businesses expect better times for the economy over the coming year, up marginally on June.

Sentiment is strong across all the sub sectors, with business confidence levels residing well north of their historical averages. The elevated readings in general business confidence continues to be reflected in respondents’ own activity outlook.

A net 44% of businesses anticipate an increase in activity, up 5 points on June. This continues to be reflected in expected gains in profits (+24, up 4 points), investment (+18, up 3) and employment (+19, up 9).

The July results are tremendously encouraging.

They have been taken amongst a backdrop of global uncertainty, softening commodity prices (from highs), firming expectations that interest rates will be moving up (a net 59 percent of respondents expect higher rates) and a rising currency, though the majority of the New Zealand dollar’s movement over the month occurred after most responses were received.

Our composite growth indicator from the survey is now pointing to 5% growth over the year ahead.

With growth in the first quarter of the year coming in at 0.8% (annualised 3.2 percent) and revisions to prior quarters, the noted mismatch between business sentiment (which has been portending of better times for a year) has been settled. Reality is catching up with the expectations.

With every step along the recovery path different challenges emerge.

New Zealand’s story looks good. Yet on a relative basis to global peers it looks remarkable, and the danger in such instances is that financial markets front-run the story so far via a higher currency and expectations of higher interest rates that one nucleus of support, namely loose financial conditions disappears before the party has moved beyond 9pm.

A net 29% of businesses expect to raise prices.

The latter is not overtly high nor a catalyst to rising rates in itself, though with a net 50% of businesses in the construction sector expecting to lift prices, the RBNZ’s June assumption of subdued construction cost inflation looks wishful thinking.

The construction sector is now leading the charge across confidence, activity, employment, investment and pricing intentions. An emergency policy setting for the OCR is no longer required. An OCR at 2.5 percent is on borrowed time.

The unwind of policy support will present challenges. We are only six months into an expansion phase (well technically nine months by the time the official data catches up!). The New Zealand dollar has been turbo-charged higher of late. The global economy remains frail. A banking sector crisis has been replaced with the potential for a sovereign equivalent.

The global economy desperately needs leadership, yet the fiscal austerity required screams of populist promises of alternative solutions. Beware such promises and magic potions - for typically they are snake-oil. There is much for the RBNZ to monitor and weigh up. The risk is that a relatively uncomplicated decision becomes complicated. Sometimes when you have a job to do, you’re better to just get it done. Brace for interest rates to move up. Call it taking the Official Cash Rate from being extraordinarily low to just exceptionally low.

BNZ economists said the firm business confidence backed its call for a September hike and raised the remote possibility of a hike on Thursday. It also pointed to signs of rising inflation in construction costs ahead of the Christchurch earthquake rebuild.

Here's BNZ economist Doug Steel's comments.

The heat is on the RBNZ to remove its emergency interest rate cut it put in place following the February earthquake. Certainly sooner than its central view of December, as published in the June Monetary Policy Statement. Based on the evidence, a September hike is looking more and more likely, as is our call. A move tomorrow, although we are not picking it, is not completely out of the question.  If the RBNZ delivered it, we would be the first to commend it for responding to the evidence and attendant inflation threats.

Even more worrying for the RBNZ is the very sharp rise in construction sector pricing intentions this month to 50.0 from 38.7 in June. This is the highest construction sector pricing intentions since 1994. In fact, these pricing intentions have only been higher than now on two occasions since the series began back in 1993. These results are in much more direct contrast to another of the RBNZ’s June assumptions, namely that ‘construction cost inflation will be subdued relative to its mid-2000s peak’. Good luck on that.

Whatever the finer details, it seems clear that the Official Cash Rate needs to be moved up from its emergency level of 2.50% and the sooner the better, in our view. On top of the 25 bp moves we expect for the September and October meeting, we see a further increment for December. This would take the OCR to 3.25% by year’s end. Our target for end-2012 remains 5.00%, on the proviso that the world does not implode. We will find out tomorrow morning how the RBNZ’s thinking has changed in light of the new information to hand.  

(Updated with charts and BNZ economists' comments.)