NZ leads the rate world

The Reserve Bank of New Zealand has stepped further out on its own with last week’s tightening monetary policy again at a time when the rest of the developed world's central banks are either holding rates at record lows or printing money. 

Or indeed, as in the case of the European Central Bank, charging for deposits – negative interest rates. 

The central bank raised its Official Cash Rate (OCR) for the third time inside three months on Thursday, lifting it to 3.25 per cent, 75 basis points clear of the Reserve Bank of Australia's cash rate target of 2.5 per cent. 

Unlike its Trans-Tasman neighbor, New Zealand's economy is firmly on an upswing - with all the inflationary pressures that brings. The rebuild of quake-ravaged Christchurch and a building boom in the biggest city of Auckland are both powering economic growth at over 3.5 per cent. Record high payouts for dairy farmers and a surge in net migration is also heating up the economy, along with annual house price inflation near 10 per cent. 

Governor Graeme Wheeler surprised the market by sticking with a hawkish set of forecasts for future interest rate increases. The Reserve Bank's forecast for 90 day bill rates implied another two 25 basis point hikes through the rest of 2014 and another four through 2015. 

Wheeler is determined to keep inflation around 2 per cent and is concerned the economy is running faster than its productive capacity of around 2.75 per cent growth. 

But the higher interest rates are coming at a cost, making the local currency much more attractive in the eyes of international investors who face near zero short term rates and falling longer term rates in their home countries. The New Zealand dollar surged again on Thursday to a two-month high of US86.7 and A92.2. 

The strong Kiwi dollar is both a headwind and a boon for the Reserve Bank. The strength of the currency has helped to take some of the heat out of inflation, given tradable prices have been deflating for all seven of the last quarters. But it is also proving a headwind for exporters and continues to be out of step with a sharp fall in commodity prices since February. 

Dairy prices have fallen 26 per cent as supply of dairy products ramps up in Europe and the United States in response to strong demand in China. A slump in demand for framing timber in China's slowing construction market has also sliced 20 per cent off the price of New Zealand log exports over the same period. 

However, New Zealand's favourable interest rate differentials have been more than enough to overwhelm the impact of the fall in commodity prices. 

Wheeler again intoned his view that the New Zealand dollar was unsustainably high but he stopped short of threatening intervention, as it had done in a speech last month. 

He also voiced his frustration that a fall in longer term wholesale rates and cheap bank funding in recent months has triggered a rash of fixed mortgage rate reductions by increasingly competitive banks. Two and three year fixed rates have fallen around 80 basis points below floating mortgage rates. 

"To be blunt, we would like to see a lower exchange rate and higher long term interest rates,” Wheeler said. “Higher long term interest rates would assist our objectives on the housing market, but a lot of that is driven by what is happening offshore.” 

He pointed to a fall in Spanish and French 10 year bond yields to 250 year lows and below US yields. "That's the sort of pressures that you're facing in terms of international financial flows, and that's putting downward pressure on long term interest rates."

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

editor's picks