By Bernard Hickey
Reserve Bank Governor Graeme Wheeler has repeated his warning from Thursday that the bank expects to increase interest rates to more normal levels soon to contain inflationary pressures building because the economy is growing faster than its potential.
Wheeler made the comments in a wide-ranging speech to the Canterbury Employers' Chamber of Commerce in Christchurch on the "Building Blocks for Economic Expansion" and what the Reserve Bank was doing to help ensure the expansion could be sustained.
He said there were signs construction cost inflation was spilling over from Canterbury and economic growth figures since the bank's December Quarter Monetary Policy Statement had been stronger than expected.
He repeated comments made in December MPS that the OCR would need to rise by around 2% over the next two years. The New Zealand dollar fell around 20 basis points to around 81.5 USc after the release of the speech.
"In the past six weeks for example, indicators on New Zealand’s economic growth and inflation have been stronger than those built into our December projections, but the exchange rate has also been stronger and initial indications are that house price inflation may be starting to moderate, although it is too soon to draw firm conclusions," Wheeler said, adding the exchange rate remained a headwind and was not sustainable in the long run.
"We recognise that the economy has been growing faster than potential growth for some time," Wheeler said.
"Although headline inflation has been moderate, inflationary pressures are building and are expected to increase over the next two years. In such an environment, there is a need to return interest rates to more–normal levels and the Bank expects to begin this adjustment soon," he said.
This wording of his comments on interest rates was no different to his statement with the bank's Official Cash Rate decision on Thursday, where the bank left rates on hold at a record low for a record 23rd consecutive time.
"Achieving this will help to ensure economic activity is kept more in line with the potential growth of the economy, thereby promoting a more sustainable expansion," he concluded.
Auckland and Canterbury
Wheeler ran through the various factors driving economic growth running at around 3.5%, in particular the reconstruction spending in Christchurch and a ramp up of house building in Auckland.
He said residential consent issuance was running at 6,000 per year, about double the rate seen in mid-2011, while the Auckland Accord was targeting 39,000 consents over a three year period starting in the December quarter of last year. Auckland Council had already designated special housing areas for fast-track resource and building consent for 15,500 new homes.
Wheeler pointed out the building surges in Christchurch and Auckland were stretching capacity and generating inflationary pressures.
"If these targets for Auckland are met over the next three years, and if 12,000 new homes are constructed in Christchurch, as predicted, then construction volumes would need to be 10 percent higher than in 2004, which represented the peak of the last building boom," Wheeler said.
"This estimate, however, assumes no growth in home building in the rest of the country. Pressures on the construction industry will also increase with New Zealand’s infrastructure needs and repairs on the remaining 42,000 leaky buildings nationwide," he said.
Faster than potential output
Wheeler said an increase in inflation pressure was inevitable as the economy was growing more rapidly than potential output growth.
He said potential output growth, slowed during the 2008/09 recession and had not regained its pre-recessionary levels. The bank estimated that over the last two years potential output had growth by little over 2% per year, compared with average GDP growth of 2.7%.
Skilled labour was becoming more difficult to find and the share of investment in GDP fell sharply in the recession and was only now back to pre-recession levels.
"Labour productivity only surpassed the pre-recession level in 2011 and OECD data suggests that multifactor productivity fell during the recession and has been slow to recover," he said.
"Price pressures are particularly apparent in the construction sector as resources are reallocated to Canterbury and Auckland from other regions and activities, and spare capacity in the economy is being absorbed at a rapid rate," he said.
"Such cost pressures could spill over into broader consumer price inflation, particularly if the construction sector reaches capacity constraints"
Construction cost inflation spreading
Wheeler said the bank was watching whether higher constructions costs in Canterbury were spilling over into the rest of the economy.
"There are signs that this is starting to happen," he said, pointing to a rise in construction cost inflation to 5% in the last 12 months from just over 2% in 2012.
Wheeler talked about potential risks to a sustainable expansion, including the potential for a rapid intensification of inflation pressures if there was a sharp fall in the New Zealand dollar, as had happened several times over the past 30 years.
Rate hike to protect NZ$?
Speaking on the last day of a week where Turkey, South Africa and Russia had either sharply increased interest rates or intervened in currency markets to arrest falling cuurrencies, Wheeler said an interest rate response to a sharp fall in the New Zealand dollar "might be warranted if it were driven, for example by portfolio investors reducing their exposure to New Zealand with few real economic factors underpinning it.
"It may not be needed if the decline in the exchange rate was driven by a sharp fall in the terms of trade."
Wheeler repeated again that a sharp fall in house prices was also a risk to the expansion, referring to an OECD study showing house prices were 25% over valued relative to incomes and as much as 60% over-valued relative to rents.
LVR limits may be working
Wheeler also briefly commented on the impact of the bank's high LVR speed limit imposed on October 1. He said the limited information available so far "suggests that housing turnover and the rate of house price inflation may be easing, but this could be due either to LVR restrictions or other factors such as house affordability."
He added it would be some time before the bank could gauge the overall effect of the measures.
Economist reaction
ASB Chief Economist Nick Tuffley said the speech made very clear that interest rates would rise steadily to more normal levels over the coming years.
"More than anyone the speech will have been aimed at the broader public, stepping out the rationale for why interest rates will soon rise (market participants have been conditioned for OCR increases for some time)," Tuffley said. "Without mentioning dates, the speech has set further groundwork for a March OCR increase," he said.
(Updated with more detail and link to speech, market reaction)
37 Comments
Articles like this really graunch my gears. Who the hecks has been driving house prices higher?
Let me see who are the two worse offenders.
Politicians
Bureaucrats
Has it been deliberate by these two groups of clowns to drive house prices higher? Yes it has.
Artificially induced inflation!
The world was aghast at Libor - but the really dirty trading by others continues.
Wheelers refernce to the Houe - price vs Rent example is very relevant here .
It indicates that demand for finance by people buying houses is being driven by cheap money .
The 60% overvalaution example in his sppech seems to indicate its probably more sensible to rent than buy right now
If rents are flat then I wonder why we see house prices rising without rents doing so in tandem.
Take Chch this appears to be the case. Clearly we have lost housing stock so rent and house prices have risen due to a genuine shortage.
So the un-answered Q for me is why isnt Auckland's rents also rising, if the model for one city is both rise, why not another? I dont see consistancy here.
regards
I don't think there is much doubt that they should have raised the rates yesterday. But the reason I think they didn't, is becuase they wanted to emphsize that thy will be raising them to give your average mortgage holderwho had either not heard about it , or had forgotten about it over the xmas break. This will then give them the oppurtunity to reveiw their arranagement and whether it will be better to fix or float. It is possibily political too, as it is an election year, and raising rates could reflect poorly on the government in at the time(although I don't think it should)
But if there are going to double it over the next 2 years, I can see that a lot of people will be hurting to pay it, as it will add a lot to the monthly payment. Even savers may not benefit by that much, as I can see banks trying to claim a bigger margin and not put up deposit rates by as much, as they are flush with cash to lend. Depositers should really put the pressure on banks to give better rates when the rates rise, and the rise should be in line with the loan rate. Don't know how they would do this though, anyone have any ideas?
Borrowers are still better to float and forget. You will pay less interest over the entire term of loan than darting about like a reef fish fixing for 2 years here & there. The 5 year fixed rates are overpriced, & 2 years gives minimal risk protection anyway.
Do you really want to pay the break fees if you decide to move/sell?
It will not take much in the way of global negative events or adverse NZ/Aus events for our economy to need interest rate cuts again. The small business & consumer economy is still fairly tentative. Some provincial areas are in decline or flatlining, govt spending is being reduced in hospitals, universities, polytechs, govt depts.....
Only problem with that is your'e suggesting the someone knows where rates are going to go over that period - you know, there are people out there niave enough to have suggested for the last 12 months that the next move would be a cut, worse still, some of the most niave were suggesting two cuts...and they are always the types who repeat it over and over again and provide zero logic to their argument (actually it's not an argument is just a repeated statement like it was fact), or worse still, ignore and down crying any others with a different view and logic around it.
See what I mean, most people have little idea about where rates will go over the next 1-5 yrs, and some, grossly so. Some people believe in risk management and are the ones that listened to the logic, took higher fixed rates over the past 12 months, and they are now sitting there at very attractive fixed levels that have them being just interested bystanders to the sweat pouring down the faces of the over-ledged.
Rob I'm not sure whether deposit rates will exactly match the borrowing rate rise, although it generally does, but what might happen in this cycle, and we've already seen some of it in the past 12 months, is that if the world doesn't blow up, as bank funding spreads reduce on their offshore borrowings, so will the gap between the OCR and deposit rates locally. Whilst NZ savers might have struggled with much lower than normal deposit rates in the last 5yrs, frankly with an OCR at 2.50% the banks have been paying them records spreads above that because of the GFC fall out which forced banks to acquire more funding from that market. Savers were getting 4% plus for 90 day deposits when in a normal market they'd be getting 2.50%, or sometimes below the OCR. Its something that one or two niave posters on here confuse as the banks having big margins when in fact the banks are having to pay investors considerably above OCR for funding and that's represents their cost of funds not the OCR.
If those spreads fall then expect that premium that investors earn to reduce, but nonetheless it will still mean that their overall rate will go up with the OCR.
I read a Treasury paper last which asked the question of why NZ and Australian interest rates are higher relative to most other OECD countries. There was no definitive answer but for some reason our economy is extremely sensitive to inflation and therefore requires a higher base rate to keep it in check.
Thats' what I get from my reading too Mike, indeed I've specifically asked the same question of a number of economists over the years, including a RBNZ one only a month ago, but really from those varied responses I just don't think anyone has a really good handle on it. For some reason or other NZ's small economy has a propensity for eleveated inflation more than most when growth rates get up to good solid levels, and inevitably whenever the RBNZ is too slow to act on that we blow up, Unfortuantely every country is different which makes it harder to compare each from the other and pinpoint the inflation issue. Some love to compare us to others who are majorly different in economic structure, savings habits, geography, politicals, laws and then say innocently "why not us"). If everyone's prepared to live in a in a dog box, with draconian laws, and minimal welfare for those in hardship, and be forced to be a saver rather than just consume, then perhaps we could have lower rates too, maybe even 1-2%...innocents as I say.
The only theory I can come up with regarding our higher fixed rates is a simple one of supply and demand. Our requirements for credit on the wholesale market is very small so perhaps our rates are predominantly determined by quantity, or lack thereof. I don't think the risk argument can be used considering our household debt levels,although one of the highest,is not that far removed from many European countries for example. Many of these nations also carry higher public debt than we do,including some of the "model" Scandinavian economies. Of course this doesn't account for our variable base rate which is much more of a mystery.
Fixed rates are a bit easier because its not the RBNZ making that call, it's the market. But how the RBNZ contains inflation through its good application, or otherwise, of the OCR is a big factor in that because in theory swap/fixed rates are an average of where the markets expects the cash rate will go over the period concerned. But you're also right, in simple terms, if people don't want your debt (e.g. emerging markets at the moment, european counties after 2008 and pre-bail outs) the demand is going to outstrip the reducing supply and you'll have much higher rates as the emerging markets are experiencing currently - not to mention a lower currency and importing inflation which gives you a higher "OCR" just to complete it.
NZ's situation is also added to by having a small financial markets, although much more highly traded and liquid than its size would suggest. But nonetheless, if a funds decided its going to take its say $500m bond investment out of NZ overnight, in the big mature markets it wouldn't create a ripple, in NZ it would push the currency so far against itself in exiting, it would have a real cost to do so. Consequency, offshore players expect/demand a premium for the illiquidity. Credit ratings (a plus for NZ because of good management) and debt levels count, there is no doubt that if we have less debt, all other things being equal, we'd have lower rates again, but the mix of all these factors makes it hard to isolate the degree of each.
All of our inflation in recent years appears to be in the government sector - rates, GST, excise on ciggies and booze, tertairy education fees. There is a great graph called ANZ Monthly Inflation Gauge on page 6 of this link
http://www.anz.co.nz/resources/3/4/341bd0a1-618c-450c-9a1e-cf405d35f823/...
Last time I looked my rates had increased at 11% per annum for the last 8 years.
Does this help explain the weakness?
Fully agree Roger.....I think we have inflation rigging by the Government sector.
Given the amount of debt the NZ Government has now I believe we will see them drive inflation excessively.
I'm watching the fragile five countries at the moment. I think we have a set up for a big game changer in market direction about to occur.
Is this why Bill English is saying that it's time for decent wage rises this year, since we ve been restrained for 4 years?
Lets manufacture a big song & dance about super-rising inflation, then wage hikes, masked by OCR hikes ...
What product/services prices will actually be restrained from OCR hikes? Petrol? Power? Rates? Uni fees? Duopoly Food prices? Any current price rises atm are all producer-pushed or imported - there is no overwhelming consumer demand.
Very true Mike, savers have done well in relative terms although you'll fail to convince your average retiree of that who is trying to live off fixed interest income. But I'm talking relative to where the NZ 2.50% OCR rate is because nothings relative to another country that was so close to tipping into a total collapse and depression that they took their "OCR" to near zero, and starting printing trillions of dollars more of their currency, the consequences of which will be seen over the next 2-3 years I suspect. Never compare yourself to the basket cases as some misguided soles who seem to think we warrant the same levels...guess who, the over-leveraged.
ZZ... Just because Singapore has 2% interest rates... don't mean its' a model for NZ to base itself on...
http://www.forbes.com/sites/jessecolombo/2014/01/13/why-singapores-econ…
Rather than interest rates start looking at credit growth and Money supply growth... in different countries
Check out the Monetary Base in USA... What could u buy with $3 trillion of monopoly money...and the world jitters because the FED is simply going to taper this rate of growth.
http://research.stlouisfed.org/fred2/series/BASE/
Super low interest rates is not a magical "economic growth" pill... it is more like a drug fix.
In our current form of Capitalism...super low interest rates = credit growth... ( all else being equal.. ie. no deflationary implosion)... don't you think..??
ZZ, as has been discussed above, for some yet unknown reason, NZ requires a higher central bank base rate to keep inflation with in the requirements of the mandate. The mandate in this country (inflation between 1 and 3%) is not disimilar to most other OECD countries. The OCR is simply finds a natural equilibrium which is produced by keeping inflation within the target range. We could set the OCR at .25 like the Fed but the consequences would likely be inflation north of 5%. Given the poor structure of our economy (our obsession with property at the neglect of productive industry) this would create significant imbalances, particularly around excessive credit growth on top of what are already strained household balance sheets.
Mike M... My own theory is that NZ is simply one cycle behind Most other Western Countries.
The Reserve Bank put out a paper last yr suggesting that the neutral interest rate had now dropped to 4.5%
In my mind the OCR is as much a function of indebtedness as much as it is inflationary pressures.
My view is that the "neutral Interest rate" is a reflection of the amoount of leverage/credit/debt within an economy.
I'm guessing that the next shock that hits us will result in an , effectively, zero % OCR.... and ZZ will have the world he wishes for...
The irony, is that our economy was sheltered from the worst effects of the GFC because of low Govt debt but also because we still had lots of "gas in the tank" ...in regards to the stimulatory effects of lowering interest rates.
What ZZ might not realize is that lowering interest rates is a "one off hit".... a stimulatory boost with higher order consequences which are... of course... unintended, but which makes our economy less robust and less resiliant to handle "shocks"..... which, of course, happen...
Yes, Roelof I agree that growing debt does lead to lower borrowing costs over the long run, especially if wage growth does not keep up with credit growth. This has particularly been the case in NZ over the last 40 years or so. If debt has increased significantly then the tightening cycle tends to decrease or slow as borrowing capacity diminishes. We are seeing evidence of this now when comparing to the last tightening phase around 10 years ago.
Roelof I see other analysis that says similar, that the neutral rate is around 4.5 - 5.00% and therefore in a tightening cycle a move back to 5.50ish is quite likely, but still a long way short of previous cycle peaks
And youre also dead right, if some get the cycle of interest rates that they want (frankly are desperate for from their language), there will be a period coming up in the next decade or two where they will have to be demanding negative interests, or dare I say it, money printing. They will demand it without once thinking about what and who got us into that situation. Of course a zero or negative interest rate will not be where the banks cost of funds will be (and therefore won't result in lower borrowing rates) because even now the investors have the banks over a relative barrel in terms of what they expect to be paid to them over OCR. When our households have doubled their debt because of suppressed interest rates, that premium will be even larger. Worse still, the RBNZ capital requirements imposed on banks will become greater and more draconian by then such that no one will have access to borrowed funds anyway.
All academic of course and not worth debating as the RBNZ knows this and will not permit it to happen because, contrary to the minority opinion here, I have never seen an extended interest rate cycle in NZ that did not crush inflation eventually, and often the economy, and most know-it-alls with it.
Grant A... I agree.... and I've learnt the hard way that the 2 most powerful economic forces on the planet are Central Banks and Govts/politicians..
regarding a Central Bank/Govts will to fight inflation... I don't think they will get serious with it until it is almost too late.... ( in a world of sub normal growth )
My view is that there has been a disconnection over the last 30 yrs between the Monetary aggregates and the CPI ( What is accepted as inflation). I think this has been largely due to a few Global deflationary forces such as financial deregulation.... wage rate arbitrage .... globalization .etc.
The deflationary effects of these forces are now largely over... and I think we are now moving into a new season with a background of inflationary forces... ( An example of that is Chinas shift out of USA Treasuries into Productive assets )... so I think any Central Bank response to inflation will be too little and too late..
At the moment the world is in a deleveraging phase.... but if it does get thru that, then I think inflation will be a serious problem....
And the biggest question is how serious will the US Fed and Govt get..???... and how long will it take them to get serious... ???
They are not the financial strength they were in the early 1980s'
You bring up good points Roelof...
However the point of the credit is to keep an even keel on the cost of money.
The way the OCR is manipulated primarily affects people who have made good choices, and throws them in with the preventative pricing crew.
ie If a business operates well and expands to meet real demand, or change in ownership, then that is good use of capital borrowing. The interest should be low as these are growth conditions.
Cheap credit is consumer spending or speculative grabs such as overbidding for houses in hopes of "next fool" being able to get same or cheap credit conditions for capital gain profits. Neither is stable, and thus these are the folks who we want to keep away from the credit bubble.
Sad thing is pushing up the OCR punishes the former group, with their slower longer term plan, as the latter group the credit price is less important than it's availability (ie a slight rise in wage will let them buy more debt, no matter what OCR).
And if English thinks the economy is doing so well, are we going to see across the board 5% cut in tax (local and central)....do that, and then I'll pass on the savings to wages. Otherwise _way_ too soon to doing more than super minor nudges in anything.
Coca-cola...anyone.?? Seems Aussie is in need of a canning upgrade.
Similarities to Tiwai Point needs a power play...me-thinks.
http://www.smartcompany.com.au/growth/economy/35411-spc-ardmona-in-cris…
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