The RBNZ’s war on inflation is not over

July 17, 2007

New Zealand economic update

RBNZ July OCR preview

The RBNZ’s war on inflation is not over - another OCR tightening now on the cards

In a change of forecast, JPMorgan now expects the RBNZ to raise the OCR to a record high 8.25% next Thursday, 26 July. Thus far, RBNZ officials' firm resolve to pull the housing market into line, frustrations over expansionary fiscal policy, and concerns about the positive flow-on effects from surging dairy prices, have fuelled the RBNZ's willingness to tighten policy. The RBNZ has raised the cash rate three times this year in order to deliver a lower inflation trajectory. With the RBNZ stating in the June MPS "A sustained period of slower growth in domestic activity will be required to alleviate inflation pressures" and Governor Bollard believing, "the risks to domestic activity appear to remain on the upside", recent upbeat economic data has highlighted the need for tighter monetary policy.

On June 29, we published a note that outlined four key criteria ahead of the July policy meeting that had to be met in order for the RBNZ to tighten again. At the time, we suggested there was a 30% probability of a further rate hike; given the way the data has printed since then, we now believe there is a 65% probability of a rate hike next week. Three of the four criteria below - business confidence, retail spending, and house prices - err on the side of arguing for another rate hike but, on their own, are not enough to push the RBNZ across the line. The most important of the four criteria for a tightening, however, nontradables inflation was satisfied yesterday, when the annual rate of domestic inflation printed at 4.1%oya.

Some of the cracks beneath the surface in some of the other data (i.e. falling housing activity rather than prices) will not be enough to offset RBNZ concerns over persistently elevated non-tradables inflation. Indeed, the accumulation of solid (albeit softening) economic indicators, and the RBNZ's inability to drag non-tradables inflation below 4%oya (non-tradables inflation has been tracking around 4%oya for the past four years - see chart), make it difficult for RBNZ Governor Bollard to dismiss the need for a further 25bp OCR hike next week.

The four key data criteria we set, in order of importance, were:

1. Non-tradables inflation, which printed on the high side of expectations yesterday. Non-tradables inflation printed at 1.1%q/q in 2Q, and remained above the psychological 4% level in annual terms (coming in at 4.1%oya). Despite the fact that much of the momentum in 2Q inflation was driven by a jump in petrol prices (up 8%q/q) and a surge in electricity costs (up 3.0%q/q), the chunky quarterly outcome and unsatisfactorily high annual level, gives the hawks within the RBNZ more than enough to squawk about. The current elevated level of inflation and likely second round impacts from rising petrol, electricity and food prices, mean that the RBNZ, which already was operating with little-to-no headroom on inflation, has more work to do;

2. NZIER Quarterly Survey of Business Opinion (QSBO), fell in-line with expectations. General business confidence dropped to -37% in 2Q (down from -15 in 1Q). The growing pessimism recorded in the survey was "widespread", according to NZIER. All key indicators of capacity usage and inflation (utilization rates, pricing, cost intentions, and difficulty finding labour) fell over the quarter and point to lower inflation pressure in the pipeline. That said, the levels of the key indicators remain high, and continued to point to the need for vigilance on the inflation front. Consumer confidence also fell over the last quarter, but the massive dairy payout and a stable labour market are providing a cushion under consumption growth;

3. House prices are showing signs of buckling, but remain elevated. According to the June REINZ report, the median house price fell to NZ$347,500 (from NZ$350,000). The REINZ report, however, contrasted with that released by Quotable Value, which reported national house prices had risen 12.2%oya (calculated over the three months ending June 2007 in comparison to the same period last year). The growth rate increased from 11.1%oya in May. Both reports showed a reduction in trading activity, and suggested that the soaring housing market has hit an air pocket.

The RBNZ, however, which focuses mainly on the QV house price series, will want to make sure the reduction in activity is not just related to cold weather, and is in fact a turn in the market; and

4. Retail sales, bounced back strongly in May. Retail spending bounced by a much stronger than expected 1.2%m/m in May, after falling 1.2%m/m in April. Core retailing, which excludes vehicle-related industries, also posted a chunky 0.8%m/m gain. The message from the retail data was mixed, though, as the major gains in retailing from food, furniture and cars, was met with sharp falls in department store and clothing retailing. The report showed retail sales have returned to the same level to that recorded in March - at the height of RBNZ's concerns over consumption growth.

ENDS

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