The New Zealand dollar jumped to a five-month high after the Reserve Bank raised the benchmark interest rate as expected and signalled further hikes are on the way.
The kiwi rose as high as 85.26 US cents, from 84.73 cents immediately before the Reserve Bank's 9am statement. The local currency recently traded at 85.20 cents.
Reserve Bank governor Graeme Wheeler lifted the official cash rate a quarter-point to 2.75 per cent in the first move of a tightening cycle, and signalled potential for a steeper track for future hikes as he tries to prevent inflation accelerating.
"While headline inflation has been moderate, inflationary pressures are increasing and are expected to continue doing so over the next two years," Wheeler said in a statement. "The speed and extent to which the OCR will be raised will depend on economic data and our continuing assessment of emerging inflationary pressures."
The Reserve Bank sees a faster pace of inflation than in its December forecast, with the consumers price index rising to 2 per cent as soon as the June quarter, a level the bank had previously expected in mid-2015. While a strong currency will keep a lid on imported inflation, the bank expects non-tradable inflation to increase to about 4 per cent.
The monetary policy statement said the bank expects "the OCR will need to rise by about 2 percentage points over the next two years for inflation to settle around the target," depending on the economic outlook.
"By increasing the OCR as needed to keep future average inflation near the 2 per cent target mid-point, the bank is seeking to ensure that the economic expansion can be sustained," Wheeler said. He's tasked with keeping CPI between a range of 1 and 3 per cent, with a target to keep inflation near the mid-point.
The central bank raised its forecast track for the 90-day bank bill rate, seen as a proxy for the OCR, by about 20 basis points from the June quarter this year, and sees the rate rising to 4 per cent by the end of 2014 and 5.3 per cent by March 2017. It had previously seen the rate increasing to 3.8 per cent by the end of 2014, and 4.8 per cent by March 2016. Yesterday, traders were betting Wheeler will lift the OCR 134 basis points over the coming 12 months, according to the Overnight Index Swap curve.
"While the RBNZ's projected path of interest rate hikes could still reasonably be described as 'gradual' compared to past tightening cycles, it won't leave much room for dallying - consecutive hikes at some stage are a given, and in our view are more likely to occur up front," Imre Speizer, market strategist at Westpac Banking Corp, said in a note before the release.
Today's hike had been fully-priced in by the market after the central bank signalled rates needed to rise as the local economy gathers momentum. Wheeler had previously been reluctant to lift the key rate because of the strength of the currency, which yesterday reached a new post-float high 79.68 on a trade-weighted basis.
"The high exchange rate remains a headwind to the tradables sector. The bank does not believe the current level of the exchange rate is sustainable in the long run."
The trade-weighted index was an average 78.18 in the March quarter, higher than the Reserve Bank's December projection of 77.4. The bank now sees the New Zealand dollar remaining elevated for a longer period of time, with the TWI staying above 77 until the end of 2016.
"The high exchange rate remains a headwind to the tradables sector, Wheeler said. "The bank does not believe the current level of the exchange rate is sustainable in the long run."
The kiwi fell as low as 84.37 US cents before recovering to trade at 85 cents, from 84.73 cents just before the statement was released.
Wheeler said local economic growth has considerable momentum, underpinned by strong export commodity prices and construction activity, and is becoming more broad-based.
"We still judge that interest rates won't need to go up quite as much as the Reserve Bank's current forecasts, but a higher peak than our previous forecast of 4 per cent is increasingly likely."
Growth has been buoyed by insatiable Chinese demand for New Zealand dairy products, making the world's most populous nation the nation's biggest trading partner, and keeping the terms of trade at a 40-year high.
The bank expects gross domestic product grew at a 3.3 per cent pace in the year ending March 31, and forecasts growth of 3.2 per cent the following year, up from a previous forecast of 2.7 per cent. Growth is forecast to moderate to 2.2 per cent in the years to March 2016 and 2017.
The Reserve Bank has held the OCR at a record low 2.5 per cent since March 2011, a move similar to most of the world's major central banks seeking to stimulate economic growth after the global financial crisis froze credit markets.
That's largely ended as the US Federal Reserve notes a stronger American economy and sounder financial system, and has hinted at further winding back its bond buying programme. New Zealand is leading the pack, widening the interest rate gap with other developed economies, as the nation benefits from booming demand for its soft commodities, a pickup in home building, and increasingly confident businesses and consumers.
ASB Bank chief economist Nick Tuffley said that given the Reserve Bank had "front-loaded its interest rate increases a little more into 2014" he now expected four OCR increases of 25 basis points each over 2014.
"We see the most likely timing as April, July and December. To us, factors such as the risk of further NZD appreciation and a lot of uncertainty over how households will react to OCR increases are reasons for expecting the Reserve Bank will not lift the OCR 3 or 4 times in immediate succession."
The timing of the general election had "at the margin" reduced the probability of an increase in September and possibly October.
The Reserve Bank's track did imply around 125 basis points (1.25pc) of increases over 2014, though with no compelling signal it will "go hard" early on in the year said Tuffley.
"We still judge that interest rates won't need to go up quite as much as the Reserve Bank's current forecasts, but a higher peak than our previous forecast of 4 per cent is increasingly likely. Accordingly, we now expect the OCR to reach 4.5 per cent by the end of 2015, with 25bp increases pencilled in for each of the Monetary Policy Statement releases."