Christchurch earthquake forces new dilemma on Reserve Bank

By Brian Fallow

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Nick Tuffley. Photo / Northern Advocate
Nick Tuffley. Photo / Northern Advocate

The Canterbury earthquake has reinforced expectations that the Reserve Bank will leave the official cash rate unchanged at 3 per cent on Thursday.

Even before the failure of South Canterbury Finance and the earthquake, the run of domestic economic data indicated the recovery was losing momentum, while concerns about the global outlook mounted.

Over the course of August the probability of another OCR increase this month, as reflected in swaps market pricing, fell from over 75 per cent to 25 per cent. The events of the past two weeks has slashed it further, to just 8 per cent.

And market economists are unanimous in expecting no change, according to the most recent Reuters poll.

With business confidence already declining, the Reserve Bank would want to err on the side of caution, and the data indicated it had time on its side, economists said.

"Monetary policy targets inflation by influencing the appetite for debt and, through debt servicing, affecting discretionary spending," ASB chief economist Nick Tuffley said. But right now credit growth is extremely weak, and in the case of the business sector credit is shrinking.

"A number of small businesses are still only just hanging on and a lift in debt servicing costs would place them under added financial stress," he said.

In addition spending in the domestic economy remains moderate, despite the average mortgage rate being at a cyclical low. While real retail sales in the June quarter were better than expected, extensive discounting is thought to have played a part in that.

The softness of domestic demand, especially in the construction sector, is expected to limit the inflationary impact of the increase in demand over the next year or so as Canterbury sets about rebuilding.

The Reserve Bank policy targets agreement - governor Alan Bollard's contract with the Government - requires him to look through the immediate inflationary effects of certain kinds of economic shock, including a "natural disaster affecting a major part of the economy".

The caveat is that he always has to worry about things that weaken confidence that this is a low inflation economy, and consumers already face an imminent increase in the GST rate which will push up prices by 2 per cent.

Nevertheless the Reserve Bank's most recent survey of inflation expectations two years ahead - by which time the GST-related spike should have come and gone - recorded a fall, from 2.8 to 2.6 per cent.

"The Reserve Bank will take considerable comfort from this, though we suspect the real test of attitudes to inflation will come next year, once the inflation peak actually occurs," Westpac economist Michael Gordon said.

Since the last interest rate decision on July 29, the labour cost index suggested wage inflation has troughed.

Employment shrank 0.3 per cent in the June quarter, partially reversing the suspiciously strong 1 per cent jump recorded in the March quarter. The unemployment rate has eased from 7.1 per cent at the end of 2009 to 6.8 per cent six months later.

The housing market remains torpid, with turnover well below the long-term average and prices falling 1.1 per cent since March, as measured by Quotable Value's quality-adjusted index.

Export commodity prices, as reflected in ANZ's index, have fallen for the past three months, though they remain high by historical standards.

"The global economy is looking more precarious than it did earlier this year," Gordon said.

"It's not all bad news, with June quarter growth turning out much better than expected in Australia, Germany, the UK and Southeast Asia. But there are signs of, at the least, a mid-cycle slowdown in the US, Japan and China, and Europe is still far from resolving its sovereign debt concerns."

But money markets do not expect an extended pause in the process of raising the OCR to normal levels - though opinions differ on where that is.

Market pricing as reflected in Credit Suisse's swaps-base indicator imply an OCR either 50 or 75 basis points higher by this time next year, while Reuters' survey of market economists found them more hawkish, with either 125 or 150 basis points of rate hikes over the year ahead.

- NZ Herald

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