Export commodity prices have joined the housing market and the exchange rate in the front row of drivers of the interest rate outlook.
"How much and how quickly interest rates rise will depend on what happens to the exchange rate, commodity prices and the extent to which the increase in house prices and construction costs feeds through into consumer price inflation," Reserve Bank governor Graeme Wheeler said when releasing the bank's December monetary policy statement yesterday.
See Brian Fallow's analysis of yesterday's Monetary Policy Statement here:
The interest rate track pencilled into the bank's projections implies a high likelihood it will start to raise the official cash rate next March from the 2.5 per cent it has been at since March 2011.
The projected track is slightly higher than in the September statement even with a higher track for the New Zealand dollar.
The bank forecasts the economy to grow around 3 per cent next year, if anything slightly slower than it is now, before easing back to around 2.25 per cent in 2015 as higher interest rates rein in demand.
Its current estimate of the potential or sustainable growth rate - the rate at which the economy can grow if there is full employment without generating inflation pressures - is between 2 and 2.5 per cent. Growing faster than that means inflation pressures will build up which the central bank has to lean against with higher interest rates.
As well as the surge in construction needed to rebuild Christchurch and address housing shortages in Auckland, it sees the boost to national income from high export prices, particularly for dairy products, as a key factor propelling growth.
The terms of trade recently jumped to a 40-year high.
"When we see something at a 40-year high we tend to assume it will decline from there," the bank's chief economist John McDermott said. The central forecasts in the statement have the terms of trade coming off, but remaining high by historical standards.
However, forward prices in recent dairy auctions suggested the near-term prospects were still very positive, McDermott said, and the statement sketches an alternative scenario in which high terms of trade last a lot longer.
While that would be likely to mean a higher New Zealand dollar, it would also boost incomes and spending while the economy was picking up, and would mean interest rates would have to rise more than foreshadowed in the central forecasts, by about 40 basis points.
"That is in stark contrast to the scenario put forward previously in which a stronger New Zealand dollar prompted lower interest rates," ASB chief economist Nick Tuffley said.
"A strong New Zealand dollar would be no impediment to high rates if it is driven by economic fundamentals."
The Reserve Bank's projections have interest rates rising 2.25 percentage points over the next two and a quarter years.
It has estimated that the neutral level of short-term interest rates, which neither stimulates nor constrains economic growth, is around 4.5 per cent.
"It is rare for interest rates to peak at neutral during a tightening cycle," said Bank of New Zealand head of research Stephen Toplis.
"Importantly, the Reserve Bank's published rate track is on a rising trend at the end of its forecast horizon [March 2016], intimating that the ultimate peak may yet be even higher, say through 5 per cent," Toplis said.
Westpac chief economist Dominick Stephens is sceptical of the Reserve Bank's expectation that house price inflation will continue at above 2 per cent a quarter over the first half of next year before slowing in the second half due partly to restrictions on high loan-to-value ratio lending.
"Real Estate Institute figures released shortly after the monetary policy statement showed that house sales fell 10 per cent in the first two months after the LVR mortgage restrictions were put in place. And we expect a further decline in house sales to come."
Borrowers should read Wheeler's lips
There was a pointed reminder in governor Graeme Wheeler's statement yesterday that his mandate is different from that of his predecessor, Alan Bollard.
Bollard's brief was to keep consumer price inflation in the 1 to 3 per cent band on average over the medium term. He was prepared to use all of the flexibility that gave him and, until the global financial crisis hit, had clocked up an average inflation rate of just under 3 per cent.
Wheeler's policy has the same target band but "with a focus on keeping future inflation near the 2 per cent target mid-point".
Underpinning this shift in emphasis is a lesson about the importance of early reining in of inflation expectations - not least with respect to house prices.
If expectations of rampant house price inflation get bedded in, the spillover into general inflation as homeowners feel wealthier and spend some of the increase in their equity can require painfully high interest rates to rein it in, with a lot of collateral damage via the exchange rate. The last cycle saw the official cash rate go to 8.25 per cent, with double-digit mortgage rates.
It is real interest rates that matter, not nominal ones. For depositors the relevant adjustment is for the CPI but for someone taking out a mortgage it is house price inflation.
When house prices are rising at 15 per cent a year as in Auckland, a mortgage rate of 5.5 per cent is an encouragement to borrow.
It would be a lot less painful to narrow that by lowering expected house price inflation than by raising nominal interest rates. But it will require both.
So the man who has brought us loan-to-value ratio curbs is planning a sustained rise in interest rates to follow. Borrowers should read his lips.