Monday, July 18, 2011

Early exit from the insurance policy?

I know - it's expectations of FUTURE inflation that is supposed to guide the setting of monetary policy. However, today’s higher-than-expected June inflation result can’t be ignored. The CPI came in at +1.0% q/q and +5.3% y/y. The Reserve Bank was forecasting +0.7% q/q and +5.0% y/y.

As with last week’s GDP result, this result makes us more comfortable with our long-held view of a +50bp hike in the Official Cash Rate in December. If anything, the odds on an earlier hike have shortened somewhat.

Think about it this way. The Bank delivered a 50bp easing in March following the second and more devastating Canterbury earthquake. This was communicated as an “insurance policy”. We didn’t disagree with the move, but we warned the Bank would have to be vigilant about taking it back at the right time, especially given our view that the economy was on the improve.

With it now clear that the economy is on the mend and having withstood the earthquakes well, at least in numerical GDP terms, the time to take the insurance policy back is fast approaching.

As you will be recall we believe that, managed well, we could see a lower interest rate cycle this time around. Constrained household budgets and deleveraging, particularly in households, is likely to keep growth in the interest rate sensitive sectors of the economy subdued for some time.

On the other side, given the structural nature of the recession, the New Zealand economy’s capacity to grow is not as high as it once was. High structural unemployment in particular means the economy will hit capacity constraints earlier in the cycle this time.

A big part of the low interest rate cycle story is the requirement the Bank is sufficiently pre-emptive in (re) starting the tightening cycle. That became especially important after the March easing because we were all of a sudden we were 50bps further away from where-ever neutral is now.

So – 50bps in December seems to us to be a “done deal”. We would not be disappointed with an earlier move.