Economists expect the Reserve Bank of New Zealand to hike the OCR to 2.75%

Economists for New Zealand's big four banks are unanimously expecting the Reserve Bank to begin withdrawing monetary stimulus on Thursday by increasing the Official Cash Rate (OCR) by 25 basis points to 2.75%.

However, they see rate hikes being slower and smaller than in previous economic recoveries and say one caveat in their outlooks for a higher OCR is a deterioration in the European financial situation.

Here are the arguments below put forward by the four economists ahead of the Reserve Bank's Monetary Policy Statement on Thursday,.

Westpac's economists expect the RBNZ to start hiking on Thursday:

We expect the RBNZ to kick off the tightening cycle with a 25bp OCR hike on Thursday.

The New Zealand economy is well into recovery mode, with growth rotating towards the goods-producing sectors and export commodity prices at record highs.

Inflation is forecast to breach the target band for the third time in five years. While this is largely the result of one-off policy changes, the RBNZ will be wary of the effects on longer-term inflation expectations. In its April policy statement, the RBNZ said that it expected to begin raising the cash rate from abnormally low levels "over the coming months".

Provided the economy continued to pan out as expected, this set the stage for a hike in Thursday's Monetary Policy Statement. Perhaps tempting fate a little too much, our comment at the time was: "Sure, European debt markets might implode in the next six weeks. But based on what we know today, we see no reason to expect a delay beyond June."

The recent developments in European markets will have thrown a slight spanner in the works, but we still think there is more than enough reason for the RBNZ to kick off the tightening cycle now.

The New Zealand economy is both recovering and rebalancing towards a more sustainable growth path, and inflation pressures are on the rise even without considering the looming spike in the headline inflation rate. Key considerations Market conditions: Europe's sovereign debt woes inject an element of uncertainty into the global economic picture. There have been occasions when policy makers have been in danger of mishandling the situation, which at worst could have led to a rerun of the seizing-up in financial markets that followed the Lehmans collapse in late 2008.

As it is, we've already seen the first steps of a flight from risk, with equities falling, borrowing costs rising, and markets fearing that a weak Europe could harm growth in its major trading partners such as the US and China. We can only guess at how RBNZ officials are viewing the situation right now, but at the release of the Financial Stability Report on 19 May they seemed reasonably comfortable.

Their view was that the EU-IMF rescue package had performed a successful 'top-kill' on Greece's short-term funding problems; they believed that the recent volatility was about markets coming to grips with the long-term sustainability of sovereign debt burdens, an issue that has been apparent for some time. The impact on New Zealand was seen as minimal, aside from a small pickup in overseas borrowing costs that they will keep monitoring.

Does that assessment still stack up? Funding costs will still be on their radar: the indicative cost of long-term borrowing for Australasian banks is about 30 basis points higher since the March MPS, though we expect the RBNZ to treat only a portion of that as persistent. But we share their view that the trade contagion angle has been overplayed.

Eurozone growth forecasts were already very weak and they haven't been cut any further, so export volumes can't seriously be argued as a fresh source of concern for the US or the Asia-Pacific region.

Exports: Europe aside, the outlook continues to improve for our most important export markets. Consensus forecasts for trading partner GDP growth have been revised up to above-trend rates of 4.0% this year and 3.8% next year. New Zealand is benefiting from increasing penetration into the fast-growing developing Asian markets, as well as our close ties to Australia, another country benefiting from Asia's growth. That has also led to a dramatic change in the prices that we receive for our exports.

Export commodity prices reached another record high in May, continuing the resurgence that was apparent last decade before it was interrupted by the global financial crisis in 2008. What's more, prices are at their highs in both international and NZ dollar terms - so even with the currency around 70c, exporters are in a strong position. New Zealand's annual trade balance has moved into surplus for the first time since 2002. While the market has been slow to grasp the implications of this, we know that the RBNZ is on top of it: stronger export earnings warranted two mentions in the April OCR review.

Domestic conditions: The indications are that the domestic economy is panning out at least as strong as the RBNZ expected. Firms' own-activity expectations are at their highest in 11 years, and hiring and investment intentions are now at above-average levels. Dwelling consents point to a pickup in construction, and manufacturing output continues to rise. The recovery has been going for so long that even the labour market has made a convincing turnaround, with the unemployment rate dropping from 7.1% to 6.0% in the March quarter. T

his might be overstating the degree of improvement - the survey uses a relatively small sample, so is always open to sampling error - but we're encouraged by the fact that the separate Quarterly Employment Survey also recorded strong gains in jobs filled and hours worked. Consumer spending hasn't been as much of a feature of this upturn, fuelling the arguments of those already sceptical of the strength of the recovery. To be more accurate, we haven't seen the interaction of rising house prices, household debt and spending that characterised the last cycle.

The tax changes in the Budget make it even less likely that we'll see a repeat of that dynamic - the most significant change being the cut in the top income tax rate to 33%, which reduces the value of the tax shield available to landlords, and could dampen house price gains for years to come. The consumer picture can't be ignored - private consumption makes up about two-thirds of GDP - but we expect consumption growth in coming years to be more in line with income growth than with asset values.

Inflation: Even in March, the RBNZ could no longer describe its inflation outlook as 'comfortable'. Annual inflation was forecast to settle around 2.7% by 2012, near the upper edge of the 1-3% target band - and that's even with projections of an extended tightening cycle over coming years. That didn't leave much wiggle room to deal with any upside surprises to growth or inflation. This time, the RBNZ will also have to deal with a sharp spike in inflation next year, largely driven by policy changes.

The increase in GST from 12.5% to 15%, effective from October, equates to a 2% increase in the CPI (some items in the CPI, such as rents, are not subject to GST). Then there are the increases in tobacco excise, and the direct impact of the Emissions Trading Scheme (which the RBNZ excluded from their baseline forecasts in March, despite it being passed into law). Plus, the timing of tax changes (income tax cuts in October, the removal of depreciation allowances in April next year) means that the Budget is more stimulatory up-front than expected, which Treasury estimates will contribute a further 0.3% to near-term inflation.

Put together, Treasury is forecasting annual inflation to peak at a whopping 5.9% by early next year. Our own forecast of a 5.2% peak is based on a higher projected track for the exchange rate, in line with our view that export commodity prices will remain at a higher level than in the past. However, picking the exact peak in annual inflation is not the point; the key issues are that inflation will be (a) well above the top of the target band, and (b) driven by one-off factors. The challenge for the RBNZ will be to distinguish between these one-off factors and the medium-term drivers of inflation.

The RBNZ can look through short-term inflation spikes, but it needs to be careful that they don't influence longer-term expectations - and with annual inflation about to reach 4% or more for the third time in five years, we can justifiably expect some scepticism about the RBNZ's stated goal of keeping inflation around the middle of the 1-3% range. The RBNZ's own survey found that firms' expectations for inflation two years ahead have risen to 2.8%, compared to 2.2% at the start of last year. Projections and market implications We think that on balance the developments since March - in particular the need to keep a lid on rising inflation expectations - warrant a higher interest rate track in the RBNZ's projections.

However, we suspect the RBNZ will be careful about how they incorporate this - the projected 90-day rate track in the March MPS was already very steep, and the RBNZ may be wary of publishing something that appears to commit itself to rate hikes at every review date. So we may see a higher interest rate track for later years, with the rest of the impact redistributed to other areas such as a higher exchange rate projection, or higher inflation over the next year or so (since they have no chance of keeping near-term inflation within the target anyway).

We expect the final paragraph of the media release, which typically gives guidance on future policy moves, to be along the lines of: "We will continue to steadily remove policy stimulus, provided that global and domestic conditions evolve as expected." This would dampen any expectations in the market of larger 50bp hikes, and would leave scope for pauses along the way if necessary.

Markets are already anticipating a 25bp hike next week, with another three hikes to 3.50% by year-end. So beyond the confirmation effect of actually delivering a rate hike, we expect the reaction in wholesale interest rates and the NZ dollar to be muted.

BNZ economist Stephen Toplis sees the RBNZ beginning to tighten monetary policy from Thursday:

If ever there was a reason why the RBNZ should start raising its cash rate sooner rather than later, the National Bank Survey was it.

In short, this survey implied that: GDP growth will soon be above trend; inflationary expectations are pushing higher; businesses know that rates are headed higher; capacity utilisation is rising; and even the lagging indicators of employment and investment are proving to be robust.

This being so, we feel more assured in our view that the RBNZ is likely to pull the trigger at this week’s MPS.

We always look to the own-activity indicator as the best all-encompassing picture of the health of the business sector. At 45.3 this was the strongest reading since May 1999 and consistent with GDP growth headed through 4.0%. This is stronger than our own forecasts and, probably, a tad stronger than that expected by the more optimistic RBNZ. (It’s certainly indicative of a more robust profile than Treasury’s Budget view.)

Interestingly, back in May 1999 (when the reading was last this strong) the cash rate was 4.5% shortly to embark on its ride to a peak of 6.5%. Clearly this cycle is not the same as that one but a worthy point of comparison nonetheless. Relative to average, the most optimistic sector was construction followed by retail.

The laggard was agriculture. Since this survey was conducted Fonterra has raised dairy payout hopes above previous expectations, the drought has ended and the NZD has fallen a couple of cents. This combination of events can only have boosted rural sector confidence. Moreover, we believe that, at the margin, the business sector will have approved of the 20 May Budget.

It was particularly heartening to see that two traditional lagging indicators of economic growth were positive. Employment intentions rose to 15.9 from 13.4 and are now at their highest level since October 2002. At these levels, intentions would tend to suggest annual employment growth rising to around 3.0%. This is modestly higher than our own pick and consistent with further significant falls in the unemployment rate. This is good news for the sustainability of the recovery and, in particular, should support retail spending and residential construction.

Moreover, it is consistent with heightened wage pressure from a tightening labour market. Investment intentions also poked their head above water. It was the first time intentions had been above average since November 2007. While it’s far from suggestive that businesses are about to spend up large, at least the series continues to trend in the “right” direction. It is also consistent with the fact that capacity utilisation growth is headed along the same path. We have long believed that some of the strongest investment this cycle would be in the residential construction sector.

Today’s survey reveals a drop in residential investment intentions but to a level that still portends annual residential investment growth rising to around 30%.

Indeed we are forecasting exactly this growth by the end of this year. In stark contrast, non-residential expectations remain low also supporting our view that this sector will contract across 2010. This should come as no surprise as first the economy needs to grow, then people need to be hired, and then existing space needs to be filled before folk can start thinking about commercial building. Another positive sign in today’s release was the strength in export intentions. While bang on average overall, a net 47.1% of manufacturers remain optimistic about their export prognosis consistent with the strength we are seeing in the BNZ-BusinessNZ PMI.

With all this confidence, it should perhaps come as no surprise to see business pricing intentions rising. In fact they have risen to the extent where they suggest an upcoming breach of the RBNZ’s target band. The problem is we don’t know how much this reflects GST-increase expectations as opposed to a return to pricing power. It was interesting, nonetheless, to see that the agriculture sector, witnessing rising commodity prices, felt most confident that prices would be pushed higher followed by the construction industry, as activity in residential activity picks up.

The sector most obviously impacted by the GST increase, retail, was one of the laggards in pricing behaviour. Putting all this together, we have to conclude that, despite the growing risks from a European implosion, New Zealand businesses still feel relatively confident that their lot is about to improve.

Given the normal implications of this for both growth and inflation, it presents a very strong argument for the Reserve Bank to at least start the process of pushing interest rates back towards neutral. And given that a net 79.4% of businesses believe rates are moving up also, then such a move will hardly come as a surprise to the business community either.

ANZ's economists see rates being hiked from June 10.

Based on local considerations the RBNZ will feel comfortable raising interest rates in June. The recovery remains patchy and there are still pockets of weakness – particularly housing. But there is no doubting that the recovery is on track. The unemployment rate is falling and commodity prices have risen strongly. There are signs that banks are starting to free up on the availability of credit, and inflation expectations are starting to drift up.

Global ructions make June itself a tight call. Some caution is warranted given volatility in financial markets as concerns over the sovereign debt situation in Europe spread. However, at present we have not seen sufficient negative impact on NZ.Inc to really say the RBNZ should not go. The banking sector continues to have access to global capital markets, albeit at a slightly more expensive rate. The US Libor rate has started to stabilise after rising over the past few weeks.

But even the increase in Libor has been gradual as opposed to the sharp spikes seen when Lehman’s went under in late 2008. But clearly there are strong reasons to be cautious at this juncture with an inevitable flow-on from what we are seeing in Europe. It is just a question of degree. The spirit of our interest rate view is one of rising rates, but in a gradual manner. Indeed, the challenge for the RBNZ is to raise rates to a more neutral setting (a somewhat arbitrary concept) without derailing the economic recovery.

Hence, the focus is very much on removing policy stimulus, as opposed to moving to a tightening stance. In layman’s terms, the RBNZ is taking the foot off the accelerator as opposed to stepping on the brakes. This is a fine balancing act considering the structural forces that are occurring at the same Our tightening profile has four consecutive 25bp hikes starting from June, taking the OCR from 2.5 to 3.5 percent by October. This is followed by a pause to assess the impact, before embarking on the next stage of the tightening cycle from early next year, which will eventually see the OCR back towards neutral. We see the neutral rate at close to 5 percent. The main message is that the policy normalisation path will be a gradual one.

Of course there is another, historically appealing, scenario where rates move to neutral and beyond relatively quickly as the RBNZ ends up “behind the curve”. This was the case in the early 1990’s and again over 2004/05. While the structural dynamics mentioned above lean heavily against this, we would never want to rule it out. “This time it’s different” is a graveyard phrase for economic (and interest rate) views.

The most likely candidates driving this scenario seem to stem from either: • the historical experience where the historical experience where once the New Zealand economy gets going, it proves difficult to rein in as we seek to return to the “old” normal, or;

• the China story being maintained and New Zealand following the Australian terms of trade experience, or;

• the diminished supply side capacity of the economy becoming problematic for the inflation outlook.

The RBNZ’s new prudential liquidity policy, alongside proposed new global banking regulation, should ensure that we do not go back to the “old” normal.

ASB economist Nick Tuffley also sees the RBNZ increasing the Official Cash Rate by 25 basis points on Thursday,.

We expect the RBNZ to increase the OCR by 25 basis points at the June Monetary Policy Statement.

Recent data have provided further evidence that a self-sustaining recovery is taking place. In particular, businesses have become more confident of a recovery in demand, and as such are planning for expansion. This is reflected in the growth in employment over the March quarter.

Furthermore, there are signs of inflation pressures building up. Recent surveys show medium-term inflation expectations continuing to edge close to the top of RBNZ target band of 3%. Added to that, there are a host of government charges over the coming year in the form of tobacco excise taxes, ACC levies, higher energy costs through the implementation of the Emissions Trading Scheme (ETS) and the increase in GST.

While these items can be looked through by the RBNZ, the combined factors are expected to push annual headline inflation close to 6% by the middle of next year and will test the RBNZ’s key assumption that inflation expectations will remain contained. Moreover, underlying inflation pressures will lift as the economy recovers.

Considering domestic conditions in isolation would indicate overwhelmingly that the RBNZ would increase the OCR in the June MPS. However, recent developments in the Euro zone have introduced some uncertainty into this decision. Fears of the sovereign debt crisis in Greece and Spain spreading to other European economies have heightened risk aversion, though there has been a stabilisation in debt markets more recently. Market pricing now implies an 80% chance of a rate increase in the June meeting.

Given the effects of the sovereign debt crisis on NZ have been limited to date, we expect the RBNZ will begin removing monetary policy stimulus at the June MPS.

Less slack in the labour market. More fiscal stimulus. High headline CPI will test assumption that inflation expectations will remain anchored. Inflation pressures have increased Recent developments have in sum lifted our inflation concerns. The Q1 Household Labour Force Survey was much stronger than expected, with the sharp fall in the unemployment rate from 7.1% to 6% indicating much less slack in the labour market. Although wage growth in Q1 was a touch softer than the RBNZ’s March MPS forecasts, the stronger employment data suggests future wage growth will be stronger than anticipated.

Furthermore, Budget 2010 shows fiscal policy being more stimulatory in the short term, as near-term expenditure rises quickly and new revenue-gathering initiatives are slower to kick in. This increased fiscal stimulus suggests monetary policy stimulus should be removed sooner. We now expect annual CPI inflation to rise to 5.5% in March 2011 and reach a peak of 5.7% by mid-2011.

This high headline result will be driven by a range of Government charges, including the increase in tobacco tax, ACC levies, GST and implementation of the Emissions Trading Scheme. The Policy Targets Agreement allows the RBNZ to look through the first-round effects of these factors. However, at a time when two year ahead inflation expectations continue to edge towards the top of the RBNZ’s target band of 3%, such a high headline result pose a risk to the RBNZ’s key assumption that wage and price setting behaviour will remain unchanged.

Developments in commodity prices have been positive, with prices for dairy, beef, and forestry lifting on year-ago levels.

In particular, Fonterra’s strong payout forecast for next season is a significant development for dairy farmers and will go some way to boost confidence in the rural sector. Against this backdrop of increased inflation pressures, there are areas where activity remains subdued. House prices are holding up impressively, but low housing turnover indicates continued slowing in housing market momentum. Furthermore, both residential and non-residential consent issuance points to a muted recovery in construction activity.

Meanwhile, credit demand remains weak. The subdued levels of borrowing undertaken by households will be in line with the RBNZ’s expectations of a rebalancing in the NZ economy as households rein in their spending. However, the RBNZ has expressed a desire to see a recovery in business credit as businesses look to invest again. Nonetheless, it looks as though a self-sustaining recovery is falling into place. Despite the weak level of business credit there have been tentative signs of a rebound in plant and machinery investment, and recent business surveys show a continued improvement in investment and hiring intentions.

This indicates that businesses are confident enough about an improvement in demand to plan for expansion.

Euro zone developments make June decision not so clear-cut. Potential effects on trading partner growth. Disruption to credit markets will be concerning. But this time looks different. Developments in Euro zone introduce some uncertainty. The inflation and activity outlooks suggest the RBNZ should go ahead with rate hikes. However, with the current uncertainties stemming from the Euro zone the RBNZ’s gut feeling may be no. Increasingly, economists and markets are starting to factor in a weaker growth outlook for economies more directly exposed to the European sovereign debt crisis.

Fiscal austerity measures will result in the government sector being a net drag on growth in crisis countries. In addition, these economies will be weighed down by higher debt funding costs. However, what is not yet clear is how the current crisis will transmit to the rest of the global economy and exactly how concerned the RBNZ needs to be. The Euro zone’s current problems have the potential to affect NZ in two ways.

First is through lower trading partner growth. However, unlike in the US-led financial crisis, few of NZ’s trading partners appear to be directly affected. In particular, the US and Asia-Pacific outlook remains robust. The larger impact on NZ is likely to come through any disruptions in credit markets, thus affecting liquidity and funding costs. To date, the impact of these has been minimal. Short-term funding spreads have started to lift, but are well below global financial crisis levels. In addition, bank funding costs have not been materially affected to date.

If conditions in Europe were to deteriorate and significantly affect NZ liquidity and funding conditions, then the RBNZ would need to rethink its entire gameplan. However, it only remains a risk this deterioration could happen and, when weighing up policy decisions, the RBNZ needs to treat it as such. Currently, the more sensible assumption is that measures by the ECB and EU members will be effective in preventing Round 2 of the global financial crisis. Another key difference between the European crisis and the US-led crisis is there appears to be more discrimination between different debt markets. Underpinning the European debt crisis has been poor fiscal control in a number of EU nations.

Lack of fiscal discipline in the ‘good times’ saw many governments continue to run fiscal deficits and increase debt levels, with little regard to keeping some safety net should the economic outlook and government revenue deteriorate. Worse still, in the case of Greece, previous governments had concealed the true extent of fiscal deficits and total debt. Transgressors are now being singled out. NZ is (for now) being positively discriminated against. The Fiscal Responsibility Act has exerted discipline on successive NZ governments. Further to that, the NZ Government is seen to be credible in its plan to return the fiscal balance to surplus and as such the NZ government and NZ economy are seen as a far better credit risk and less affected by Europe’s surge in government bond yields.

Implications: RBNZ likely to go ahead with OCR increase

Domestic conditions alone would overwhelmingly point to a 25bp OCR increase in the June MPS. Given interest rates typically take up to two years to fully impact on inflation, central banks need to look ahead and decide on the appropriate monetary policy settings based on upcoming inflation pressures. A host of government charges over the coming year will lift headline inflation. Granted, the expected increase in annual CPI to close to 6% by mid-2011 is largely due to tobacco excise taxes, ACC levies, higher energy costs through the implementation of ETS and the increase in GST.

The Policy Targets Agreement allows the RBNZ to look through the first-round effects. However, the fact that annual inflation is expected to rise close to 6% next year when medium-term inflation expectations are already close to the top of the inflation target band pose a very real risk of a change in wage and price setting behaviour. It is this risk of unanchoring inflation expectations – on top of an underlying lift in inflation pressures – which the RBNZ needs to heed more. Furthermore, the release of the Budget on May 20 eliminated a key uncertainty in domestic conditions.

The removal of the ability to claim depreciation on most buildings including rental and commercial properties is helpful for monetary policy in the medium term. However, there is actually more fiscal stimulus in the economy over the coming year via the sequencing of policy changes. Against the backdrop of a self-sustaining recovery, the RBNZ will need to act in a timely manner to contain these stronger inflation pressures. Hence, a June rate increase would be clear-cut if not for the recent developments in the European region.

Concerns that the European debt crisis will make accessing offshore funds difficult and lower demand for NZ’s exports have introduced some uncertainty into the June rate decision. Nonetheless, given the effects on the NZ economy to date have been limited, we expect the RBNZ will go ahead with reducing monetary policy stimulus at the June MPS.

Beyond the decision over the timing of the OCR increase is the amount of further increases that will follow over the coming year. Given the higher degree of uncertainty over how the economic recovery will now evolve there is the potential for the RBNZ to pause at some point in its tightening cycle. How the RBNZ weighs up the stronger domestic outlook with the tighter credit conditions in European markets will provide some insight into the extent and pace at which monetary policy stimulus will be removed. Markets look to be erring on the side of some risk of a pause during the tightening cycle.

As we currently see a greater chance of a pause from the RBNZ than 50bp rate rises that stance seems appropriate.