Wednesday, April 16, 2014

NZ CPI lower than expected but tightening to continue

New Zealand’s March quarter CPI came in lower than expected at +0.3% q/q/ for an annual rate of +1.5%.  That’s a tad lower than the 1.6% recorded for the year to December.  Market consensus was for a quarterly increase of +0.5% and an annual rate of 1.7%.  However, we don’t expect the Reserve Bank of New Zealand (RBNZ) to be in any way deterred from continuing the gradual removal of monetary accommodation in the months ahead.

The surprise in the result was the softness in tradeables inflation which came in at -0.7% q/q and -0.6% y/y with the downward pressure on prices coming from the strong New Zealand dollar.  That decline was more than offset by a 1.1% q/q increase in non-tradeables inflation which is now running at an annual rate of 3.0%.  Key contributors on that side of the equation were the expected increase in tobacco excise tax, but also continued strong increases in construction costs which are now running at an annual rate of 5.1%.

We don’t expect this result to deter the RBNZ from pressing ahead with the gradual withdrawal of monetary stimulus.  The reality is that GDP growth is running well ahead of potential, spare capacity is being absorbed and firms are finding it more difficult to find skilled labour and interest rates are still at exceptionally low levels.

Those factors being the case we still expect the RBNZ to lift the Official Cash Rate 25bps in each of April, June, September and December for an OCR of 3.75% by the end of this year, with continued tightening in 2015 taking the OCR to 5.25%.

That said, there are many factors that will ultimately determine the quantum and pace of the tightening cycle.  These include whether the RBNZ has been (and remains) sufficiently pre-emptive, how the economy responds to higher rates, where the neutral OCR is, what New Zealand potential growth rate is and, of course, the path of the exchange rate.

With respect to the exchange rate our interest rate forecasts assume some eventual downside in the New Zealand dollar.  Recent falls in commodity prices haven’t yet proven the catalyst for a weaker currency but we expect that as the Reserve Bank of Australia starts to hike rates later this year and as the US Federal Reserve moves closer to interest rate increases we will see some downside in the NZD.  If none of those work, the catalyst for the lower NZD will likely prove to be a downward revision of our and, more importantly, the Reserve Bank’s interest rate projections! 

But remember exchange rate risks are not one-sided. A sharper than expected fall in the exchange rate could lead to higher inflation and higher interest rates.