New Zealand's economy hits the sweet spot

Given inflation is contained and the construction boom is yet to overheat the economy, New Zealand's central bank sits in an auspicious place - and should approach a rate rise with caution.

Inflation in New Zealand remains fairly mild but the Reserve Bank of New Zealand is set to raise rates sooner rather than later. Is that the right decision?

In New Zealand, consumer prices rose by 0.1 per cent in the December quarter, beating expectations of a modest fall to be 1.6 per cent higher over the year. Core inflation – which removes volatile items such as food and energy – rose by 0.7 per cent in the December quarter to be 1.7 per cent higher over the year.

Graph for New Zealand's economy hits the sweet spot

There is a growing belief in New Zealand that the RBNZ will raise the cash rate by its March meeting and perhaps even earlier. It is no surprise given economic growth in New Zealand is expected to be well above trend in 2014 and among the strongest in the OECD (Can Australia fly on Kiwi wings?, January 14).

Construction is booming (albeit due to the rebuilding of Christchurch), business sentiment is at an all-time high and there are widespread concerns that the housing market is overheating.

Under such circumstances the RBNZ should raise rates, but the urgency is not as strong as many expect. The RBNZ should take a cautious and considered approach when it begins to tighten.

First, while rebuilding Christchurch has done wonders for GDP growth, the reality on the ground is that living standards have deteriorated for people living in the region. Times have rarely been tougher for those living in the Christchurch / Canterbury area; it is a region that will prove particularly susceptible to higher interest rates.

It is an unfortunate quirk of GDP calculations that disasters are good for economic growth. But the RBNZ cannot ignore that when setting policy. Interest rates don’t care who or what is driving growth, employment or inflation.

At the same time, they should, if possible, try to set rates in order to provide sufficient capacity for the construction sector while continuing to support the non-construction sector. The long-term growth prospects of the New Zealand economy will only be enhanced if those most affected by the Christchurch earthquake remain a part of the productive economy.

Second, inflation remains contained despite concerns that a lack of spare capacity in the construction industry could create wage pressures. Perhaps the bigger factor will be expectations that the New Zealand dollar will continue to appreciate, potentially hitting parity against the Australian dollar. If this eventuates, then there is no reason to be scared of rising prices.

The prices of tradables have already fallen in New Zealand over the past year and that will continue in the near-term. The result is downward pressure on New Zealand prices. There might be some concerns regarding non-tradables inflation, but they are also fairly contained by historical standards.

Graph for New Zealand's economy hits the sweet spot

Third, macroprudential policies appear to have reduced risky lending practices in the housing market. Prior to the introduction of the macroprudential policies on October 1, loans with loan-to-valuation ratios above 80 per cent accounted for about a quarter of all new mortgages. Now they are around half that level.

House prices fell by 1 per cent in December and loan activity has slowed significantly. Early indications are that LVR caps have already had an impact and the likelihood of the housing market overheating has diminished.

The RBNZ will raise rates by March – that much seems clear – but it shouldn’t move too fast. There is no urgency; the economy is unlikely to become overheated despite the construction boom.

Relatively low inflation and fewer housing concerns suggest that the RBNZ can keep rates fairly loose in 2014. Consequently, I believe that the RBNZ is in a sweet spot where it can raise rates in 2014 to around 3 per cent and provide sufficient spare capacity for the construction sector but also support for the non-construction sector.

InvestSMART FORUM: Come and meet the team

We're loading up the van and going on tour from April to June, with events on the NSW central & north coast, the QLD mid-north coast and in Perth, Adelaide, Melbourne, Sydney and Canberra. Come and meet the team and take home simple strategies that you can use to build an investment portfolio to weather any storm. Book your spot here.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Related Articles