A delicate balancing act for the RBNZ

New Zealand is well-placed for growth, but the central bank's decision to make room for an unprecedented construction boom is not without its risks.

After four consecutive meetings where it hiked rates, the Reserve Bank of New Zealand left interest rates unchanged at its September meeting as it takes the opportunity to monitor the effects of tighter policy and the recent decline in commodity prices.

The cash rate in New Zealand remained at 3.5 per cent in September. Rates have increased by 100 basis points since the RBNZ began its tightening phase in March.

Although the central bank is keen to monitor developments before making their next move, it maintains a strong tightening bias, with the New Zealand economy expected to grow by around 3.7 per cent in 2014.

“We expect some further policy tightening will be necessary to keep future average inflation near the 2 per cent target mid-point and ensure that the economic expansion can be sustained,” said RBNZ governor Graeme Wheeler.

For now, inflation remains moderate, which is precisely why the RBNZ can take a break to assess developments. Headline inflation rose by 1.6 per cent over the year to the June quarter, and measures of core inflation (which remove volatile items such as food and energy) have eased recently.

Graph for A delicate balancing act for the RBNZ

The pressure on inflation is primarily to the upside. Wheeler believes that the exchange rate could fall significantly, placing upward pressure on headline inflation. Inflation will come under further pressure as the economy continues to absorb spare capacity (particularly throughout the construction sector) and wage demands rise.

“The exchange rate has yet to adjust materially to the lower commodity prices,” Wheeler said. “Its current level remains unjustified and unsustainable.”

If sustained, the fall in export prices for dairy and timber will begin to weigh on income growth and provides a modest downside risk for the broader economy. But while a strong terms of trade has been the icing on the cake, it is New Zealand’s construction sector that will continue to drive growth over the next couple of years.

The task for the RBNZ is simple: create sufficient spare capacity within its non-construction sector to allow the rebuilding of Christchurch and Canterbury without creating an outbreak of inflation across the broader economy. The construction sector will need to call on resources such as credit, capital and labour from the rest of the economy to facilitate the rebuild.

That story should be familiar to Australian readers. The Reserve Bank of Australia faced a similar challenge when it raised rates by 175 basis points from October 2009 to November 2010 to create room for the mining investment boom.

While such actions are obviously warranted by its mandate and necessary to contain inflation, they are not without their risks. By making room for an unprecedented construction boom, the RBNZ is implicitly reducing the competitiveness of the non-construction sector. Growth will be strong across the broader economy but there will be individual pockets within New Zealand that will genuinely struggle over the next few years.

Conditions in the housing sector have eased and the number of mortgage approvals has declined by 11.6 per cent over the year. The introduction of macroprudential policies last October, in addition to a higher interest rate, appear to be having the desired effect on house prices. 

The New Zealand economy is comparatively well-placed and should continue to grow strongly over the next couple of years. Lower commodity prices may present some risk but they could also be a blessing in disguise for some sectors if it prompts the RBNZ to be less hawkish.

Inflation is almost perfectly placed and provides an opportunity for the RBNZ to take a break and assess conditions over the remainder of this year. At present, the New Zealand economy is taking these hikes in its stride and there’s little evidence that the economy won’t continue to grow at a solid pace in the year ahead. Interest rates are set to rise again in the first half of next year.