What To Expect On OCR Day

The recent Inflation data out for New Zealand presents an interesting challenge for the Reserve Bank of New Zealand. For a long time, the market has been expecting interest rates to rise and this has been backed up by the RBNZ themselves. But do the latest figures change things?

Previous Comments
In March, the Reserve Bank of New Zealand Governor, Graeme Wheeler, raised the Official Cash Rate (OCR) by 25 basis points from a record low of 2.50%and said he may increase the benchmark by a total of 125 basis points this year to contain inflation. At the time, he had said rising inflation is being driven by the strong economic expansion and is increasingly broad based. The main reasons for the increase in demand pressures are: the Terms of Trade are at a 40-year high; dairy prices up 43% from the previous 12 months; the rebuild of Christchurch getting underway; increased Immigration adding housing and consumer demand pressures; and Business and consumer confidence being at very high levels.

Governor Wheeler said the RBNZ is going to keep inflation expectations contained to sustain the recovery and expansion for as long as possible. The RBNZ is acting early and needs to raise rates to a level that no longer adds pressure to demand. The level to which they raise rates will depend on data but these are strong signals from the RBNZ that rates will rise further. This is why the market is pricing in the probability of a rate rise this week at 97%.

CPI
Last week’s CPI figures showed prices only rose 0.3% for the quarter ending in March, below the 0.5% the market was anticipating. This puts annual price inflation at 1.5% compared to 1.6% in the December quarter. The market is currently pricing in a 111 basis point rise by the end of 2014, down from 117 at the beginning of last week, so clearly the latest CPI figures have had an effect. The CPI is comfortably in the lower half of the RBNZ’s target band of 1-3% and this might play slightly on the mind of Governor Wheeler.

Dairy Prices
One major factor the RBNZ will consider when deciding to raise rates is that dairy prices have fallen for 5 auctions in a row to US$4,047 per tonne and are now down 19.7% from 4th February this year when they hit US$5,042 per tonne. Dairy prices will start to curb export returns which will no doubt have an effect on the Terms or Trade and demand in general. Dairy exports amounted to $13.7 billion and make up 30 per cent of New Zealand's merchandise exports and so warrants consideration from the RBNZ.

Strength in the Kiwi
Since the last Monetary Policy Statement, the Kiwi dollar has strengthened considerably, pushing up by 8% against the US Dollar. This has dampened import prices which will have an effect on future inflation as they are now cheaper to buy for consumers. On the flip side, the high Kiwi Dollar has eroded the competitiveness of New Zealand’s exporters, especially for products that can be sourced from elsewhere like dairy, beef and wood. Reducing stimulus further by raising the OCR will only result in support for the Kiwi at these high levels as investors are attracted to the high yield offered on Kiwi Dollar investments.

Neutral Rate
The RBNZ has said it is targeting a neutral rate over the next two years. This is a rate level that is neither stimulating the economy, nor looking to rein it in. The RBNZ believes a 200 point raise from the historical low of 2.5% to 4.5% would result in a neutral rate and act to prolong the expansion at sustainable levels for as long as possible. So it should be no surprise that further rate rises are on the cards, raising it from a stimulating position given the strength of the local economy. But what exactly a neutral rate is remains to be seen.

Looking Forward
The market is anticipating a raise of the rate in April, June, July and August before taking stock of the situation. The market is 97% sure the RBNZ will raisethe rate this week, so do not expect a shock to the exchange rate if and when this happens. The real movement to the Kiwi Dollar will come on the back of comments from RBNZ Governor Wheeler which should, and will, be scrutinised with a fine tooth comb. This will give the market an insight into the logic of the central bank Governor and what to expect from him in the future. If he talks about the lower inflation rate, dairy prices coming down and a high Kiwi Dollar putting pressure on things, then he could signal the central bank could be reluctant to raise rates to the full 100 bp this year. We may see a more “wait and see” attitude from him when it comes to the upcoming rate reviews. On the other hand, he could talk about Business and Consumer confidence still being high and net migration remaining robust, adding to upward pressure on inflation. In this case, he may see the need to stick to the plan of 4 more rate rises this year.

So, what should we expect?
Firstly, expect the rate to rise. New Zealand’s economy does not need the stimulus it is currently receiving with such a low rate. Secondly, we will see Governor Wheeler talk about the recent events such as the high Kiwi Dollar, inflation slowing slightly, dairy prices reducing, migration remaining strong and confidence lingering at high levels. Will he see enough of a reduction in upward pressures to take a less hawkish tone than at the previous Monetary Policy Statement? It is very much a possibility and the reduction in the swaps curve suggest the market is leaning that way too. He may signal to the market that four rate rises this year may not be necessary. This is what will move the market and could surprise some.