Thursday, January 23, 2014

Inflation and monetary policy in NZ and Australia

There were two inflation surprises this week, one here at home and the other across the ditch in Australia.  However, those surprises are unlikely to prompt surprise responses from either the Reserve Bank of New Zealand (RBNZ) or the Reserve Bank of Australia (RBA).

New Zealand’s December 2013 quarter CPI came in at +0.1% qoq and +1.6% yoy.  The quarterly print compared with expectations of -0.2% from the RBNZ, -0.1% average market expectations and our forecast of zero.

We have a situation In New Zealand in which GDP growth is heading towards 4% (compared with potential growth which we estimate at around 2.0% to 2.5%), inflation is heading towards the mid-point of the target band and the Official Cash Rate is 2.5%, some two percentage points away from the RBNZ (and our) estimate of neutral.  Spot the odd one out; it’s not difficult.

With higher growth looking more assured this year for all the reasons I’ve written about before (click HERE to go to the December 2013 issue of New Zealand Insights), the challenge for the New Zealand economy in 2014 is to curb excesses and manage constraints.  Remember it’s not the absolute level of growth that concerns the RBNZ; they are worried about growth relative to the potential of the economy to grow.  Growth in excess of potential absorbs spare capacity and eventually puts upward pressure on prices.  Apart from maintaining low and stable inflation, the RBNZ can do little to influence potential GDP. That’s largely in the hands of firms, government and decisions by individuals about education and training.

New speed limits on high LVR lending are doing a part of the job, but higher interest rates were always going to be part of the equation.  Regular readers will recall I thought the RBNZ should start the tightening process in December last year.  Indeed if I were the RBNZ right now, I’d prefer to have 25bps under my belt already.  Given this year’s challenge, the risk is the RBNZ falls behind the problem.

When the RBNZ didn’t tighten in December last year I shifted my first rate hike expectation to +50bps in March (and +125bps in total in 2014 for an OCR at 3.75% by December this year).  Given this inflation result, I’m even more confident in that expectation.  While it’s a possibility I don’t think they will hike rates at the OCR review next week, although I obviously wouldn’t complain if they did.  While I haven’t agreed with everything they've said and done I give the RBNZ 10/10 for their recent communications strategy; I think they would prefer to wait for the March Monetary Policy Statement when they get a better opportunity to tell their story.

And what about the exchange rate?  As I’ve said before, I think the RBNZ is worrying too much about the New Zealand dollar.  The NZD is where it is for a whole host of reasons, not the least of which is historically high commodity prices.

The other inflation surprise this week was in Australia where December 2013 quarter inflation came in at +0.8% qoq.  That followed the surprisingly high 1.2% qoq increase in the September quarter.  While that’s 2.0% in only six months, the annual rate is only 2.7% for the year to December on the back of low prior quarter out-turns.

The situation in Australia is different from that in New Zealand.  Over there growth has been slowing, the RBA has been easing and the Australian dollar has been falling.  It’s not surprising that inflation has moved higher on the back of the exchange rate depreciation.  Given that’s the case, the RBA will “look through” the recent higher than expected results.

While our Australian economics team is seeing encouraging signs in business confidence, housing construction and retail sales, they expect the RBA to sit on their hands with the cash rate at 2.5% until mid-2014.