Where are New Zealand interest rates heading?

The New Zealand economy continues to perform strongly.

Consumption growth is solid, underpinned by high levels of immigration and a very healthy labour market. It will be further boosted by the recently announced tax cuts.

Government spending is growing moderately with a reasonable volume of infrastructure spending underway. Business confidence has dipped in recent months, but firms are still investing as shown in the 6 per cent increase in business investment in the latest figures (year to December).

The export sector looks healthy overall, with dairy prices now up 62 per cent over the past year and the tourism boom continuing.

Given all this, it should be no surprise that we are starting to see signs of higher inflation in NZ.

Prices rose 2.2 per cent in the year to March, the highest in five years and now just above the middle of the Reserve Bank of New Zealand’s (RBNZ) 1-3 per cent target band. This was partly driven by fuel and food prices, but underlying price growth has also moved higher.

New Zealand Inflation 2002-2017 

_{Source: Bloomberg}

How will the RBNZ react to this situation?

The Reserve Bank of New Zealand (RBNZ) is one of the only central banks globally that provides interest rate forecasting alongside its Official Cash Rate (OCR). This gives us a unique window into how it might react to the current economic climate.

At present, the RBNZ is forecasting no change in the OCR until late 2019. This is driven by its expectation that inflation is going to struggle to move much higher from here.

Another key factor in the interest rate outlook is what is happening overseas.

The prospect of President Trump’s growth policies leading to a turbo-charged US economy (and hence higher inflation and interest rates) have dimmed significantly. This is because the President’s inflationary growth policies – tax cuts, infrastructure spending, immigration curbs – all appear much more difficult to pass into legislation given the rocky start to his tenure.

That said, global growth is strong at present as economies in Europe, the US and China are all performing well.

This should still give the US Federal Reserve room to increase interest rates next month, and probably once more by the end of the year.

Our currency is also a key consideration for the local interest rate outlook.

Despite a jump in the past fortnight, the NZ dollar has moved slightly lower this year on a trade-weighted basis (down 1.5 per cent YTD). A lower currency provides support to our exporters and lifts the price of goods that we import from overseas. This puts a marginal amount of upward pressure on interest rates.

We also have an election in September and a change of Governor for the RBNZ in that same month. Governor Wheeler is not seeking a second five-year term, so Deputy Governor Grant Spencer will step into the role for six months until a full-time replacement is found. We think that both factors will lean the bank towards leaving rates unchanged over that period.

Bringing all this together, our view at Milford is that the RBNZ is likely to see out 2017 with the OCR unchanged at the current level of 1.75 per cent.

However, we think that as inflation pressures in NZ gradually grow, there will be a need for higher interest rates and we expect 1-2 increases of 0.25 per cent over 2018.

Two final points to remember:

Firstly, our economy remains very exposed to the fortunes of the housing market. If the current softer housing market conditions (especially in Auckland) build to a sizable price decline (>10 per cent nationwide), then all bets on higher interest rates are off – indeed, the discussion will then move to interest rate cuts.

Secondly, higher interest rates do not mean moving the OCR back to 4 per cent, 5 per cent or especially the 8 per cent-plus rates of a decade ago. Households in NZ simply carry too much debt, in our view, to prosper if interest rates got that high. And in a world of low interest rates, the currency impact would be colossal.