Reserve Bank on horns of dilemma

Reserve Bank Governor Graeme Wheeler, left, with Deputy Governor Grant Spencer. Photo / Mark Mitchell

Unchanged OCR expected, but rising house prices and high dollar two diametrically opposed risks.

With no change in the official cash rate expected when the Reserve Bank reviews it on Wednesday, the focus will instead be on any hints in the accompanying statement about which of the horns of the bank's dilemma is the sharper.

The dilemma is created by the combination of a rising dollar and rising house prices. The OCR has been steady on 2.5 per cent for two years and in its March monetary policy statement the bank signalled no change for at least the rest of this year.

"But recently this has started looking less like sitting pretty and more like sitting on the fence," said Westpac chief economist Dominick Stephens. "And that's becoming an uncomfortable place to be."

The March statement indicated that if the exchange rate were to stay high and continue to suppress inflation, OCR cuts might be on the agenda.

But in a speech two weeks ago deputy governor Grant Spencer said that if the housing market were to stay strong and fuel a consumption boom the OCR might have to go up early.

"There is no contradiction between these two statements. They simply reflect the fact that the central bank faces two diametrically opposed risks," Stephens said.

In the latest Reuters survey of market economists, most do not expect the bank to start raising the OCR until the March quarter next year.

Since the March statement the New Zealand dollar has continued to appreciate, to an all-time high on the trade-weighted index and to a level about 4 per cent higher than the average for the current quarter the bank assumed in its most recent forecast.

The exchange rate's disinflationary impact is starkly evident in the March quarter numbers last week. Tradeables inflation was minus 1.1 per cent over the past year, keeping overall annual inflation below 1 per cent for the third quarter in a row.

The other side of the appreciating coin is challenging times for exporters and firms competing with imports. It frustrates the rebalancing of the economy that by common consent needs to occur and it tightens overall monetary conditions.

All else been equal it would argue for a lower OCR - not that that would necessarily lower the exchange rate but because it would compensate for the monetary tightening coming through the exchange rate.

But all else is not equal. The housing market is going from strength to strength, at least in Auckland and Canterbury.

The Real Estate Institute's stratified housing index rose 8.6 per cent nationwide in the year to March, led by a 16.1 per cent rise in Auckland. Turnover last month was at a six-year high, and the average number of days it takes to sell fell.

The Reserve Bank warned last month that it "does not want to see financial stability or inflation risks accentuated by housing demand getting too far ahead of supply".

The threat to financial stability comes from the fact that the starting point, as a legacy of the last housing boom, is high household debt relative to incomes, and from a growing proportion of high loan-to-value ratio lending associated with house prices which are also, by historical standards, high relative to incomes.

The threat to inflation would arise from a return to the conditions of the last boom, when household spending grew a lot faster than incomes on the strength of rising housing equity. The most recent gross domestic product data - surprisingly strong 1.5 per cent growth in the December 2012 quarter - was underpinned by a 1.6 per cent rise in household consumption.

Two of the other major influences on the economy remain unchanged since the March review: the stimulatory effects of the Christchurch rebuild will broadly offset the contractionary effects of fiscal policy. And the combination of autumn rains and high dairy prices will mitigate the impact of the summer's drought.