The RBNZ shifts into neutral, for now

The Reserve Bank of New Zealand's more dovish outlook for interest rates marks a big departure from recent months, but it won't be able to sit on the fence for long.

The Reserve Bank of New Zealand has reverted to a more neutral stance on monetary policy, which suggests that rates will remain unchanged for some time. But with the Canterbury rebuild still in the works, it appears likely that rates will need to rise further to moderate strength within the non-construction sector.

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

This meeting marked somewhat of a change in tone for the RBNZ. Its clear tightening bias has gone in favour of a more neutral, some would say dovish, outlook for interest rates.

The RBNZ expects to keep the cash rate on hold for some time. According to the bank, "future interest rate adjustments, either up or down, will depend on the emerging flow of economic data".

That marks a big departure from last month when the RBNZ said that “some further increase in the [cash rate] is expected to be required at a later stage". That may still come to pass, but at least for now all bets are off.

Real GDP growth has been solid in New Zealand and is expected to remain that way during 2015. Construction activity will support growth -- mainly through the Christchurch and Canterbury rebuild but also due to high net migration -- while the household sector is expected to receive a boost through lower petrol prices.

According to the RBNZ, “world oil prices have fallen by 60 per cent since June last year”. As a result, the price of regular petrol has fallen from a national average of $2.23 in mid-2014 to $1.73 at present. This has effectively acted like a tax cut -- one that benefits lower income earners the most -- and has increased the purchasing power of household incomes.

Under the circumstances it is no surprise that inflation in New Zealand has eased considerably. Headline inflation was up only 0.8 per cent over the year to the December quarter. Even the core measure -- which removes the effect of volatile items such as food and energy -- rose by just 1.0 per cent over the past year.

Numbers in that range lend themselves to speculation. Could the RBNZ reverse course and cut rates so soon after beginning its tightening phase? I’m not sold on that even with the RBNZ themselves sitting on the fence.

First, the Canterbury rebuild remains in its infancy. When the RBNZ began its tightening phase, its task was simple: create sufficient spare capacity within its non-construction sector to allow the rebuilding of Christchurch and Canterbury to go ahead without creating an outbreak of inflation across the broader economy.

That process requires the construction sector to call on resources -- such as credit, capital and labour -- from the rest of the economy. Wages and credit should begin to surge, boosting activity, and reducing spare capacity across the economy. It’d be surprising whether a cash rate of 3.5 per cent was sufficient to facilitate this transition.

Second, the New Zealand dollar remains above its fundamental value and is expected to depreciate in the short to medium term.

According to the RBNZ, “the exchange rate remains unjustified in terms of current economic conditions, particularly export prices, and unsustainable in terms of New Zealand’s long-term economic fundamentals”. It expects the dollar to depreciate significantly, and that will flow through to higher inflation among tradeable goods.

However, in the near term, the dollar could strengthen somewhat due to weakness in Australia -- particularly if the Reserve Bank of Australia cuts rates in February -- and quantitative easing measures undertaken in Europe and Japan. On the other hand, it’s reasonable to expect the New Zealand currency to depreciate against the US dollar in the months to come.

On balance, the New Zealand economy remains in a good position. Lower oil prices will support the household and business sectors and presumably flow through to greater job creation and wage demands. Its terms of trade remain elevated and is expected to remain that way, supporting income growth, which suggests that the RBNZ will need to eventually jump off the fence and begin raising rates further during the second half of this year.