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)
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