Hawkish Reserve Bank lifts OCR on fear that inflation could undermine recovery.

Another increase in the official cash rate on July 24, to 3.5 per cent, is more likely than not, say economists, after the Reserve Bank accompanied its expected rate hike yesterday with a hawkish appraisal of the outlook.

When shorn of "ifs" and "buts" the bank's central message is that the economy is growing more strongly than it expected at around 4 per cent and more strongly than it can sustain without inflation becoming a problem that threatens to undermine the recovery. It reckons the potential or sustainable growth rate right now is around 2.75 per cent.

The forward track for short-term interest rates it has pencilled in is almost unchanged from the March statement.

Its central forecast is still for a cumulative 200 basis points (or 2 percentage points) of OCR rises by the end of next year, of which 75 points has been delivered.


The Reserve Bank is having to lean against the fact that while it is raising short-term interest rates and signalling more of the same to come, longer-term wholesale rates have been falling, lowering banks' funding costs.

The banks in turn have lowered the mortgage rates they offer for two and three-year fixed term loans in particular.

It appears overseas investors are more sceptical of New Zealand's growth prospects and inflation risks than local banks or the central bank itself.

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At the same time the flow of retail deposits into the banks, more than half their funding, has kept running strong, so six-month deposit interest rates have remained steady for the past year and the spread between those rates and the OCR has fallen by abut 100 basis points over that period.

The net effect is that compared with the start of the year two- and three-year fixed mortgage rates are around 15 basis points lower, while floating rates (ahead of yesterday's OCR rise) have risen 50 basis points.

But despite a shift from floating to fixed mortgage rates, governor Graeme Wheeler said monetary policy still had plenty of traction in the mortgage belt. The average time before a mortgage faces repricing (as of the end of April) was less than 10 months, he said.

Bank of New Zealand economist Stephen Toplis said the statement was more hawkish than the financial markets were expecting and they responded by pushing wholesale interest rates between 5 and 7 basis points higher and the kiwi dollar more than half a cent higher against the US dollar.

The key guidance paragraph of the Reserve Bank's announcement is that "the speed and extent to which the OCR will need to rise will depend on future economic and financial data and its implications for inflationary pressure".

That added the phrase "and financial" to what the bank had said previously. Wheeler told the Herald that financial data would include asset prices like house prices and mortgage rates.

But he also emphasised the degree of uncertainty around forecasts of the key drivers of the economic outlook - net migration (surprisingly strong), exchange rates (still unsustainably high), export prices (falling, in dairy's case at least), housing markets (slowing) and construction (going strong).

Reflecting historical volatility in these drivers the bank has modelled about 1000 permutations and combinations, expressing the results in a "fan" of outcomes for inflation and interest. While the central forecast is for 90-day interest rates to be 4.7 per cent by the end of next year, two-thirds of the potential scenarios fall within a range of 4 to 5.5 per cent, while inflation is forecast to be 1.9 per cent, give or take 0.5 percentage points.

Westpac chief economist Dominick Stephens said: "With 75 basis points already under its belt, each subsequent OCR review becomes a little less pressing and more contingent on the flow of data. That said, our reading of today's statement is that the Reserve Bank's base case is for a fourth consecutive hike at the July OCR review and the onus is on the data to persuade it otherwise."

ANZ chief economist Cameron Bagrie said competition among banks and lower funding costs meant the Reserve Bank needed to be more aggressive. "We are still picking 100 basis points of hikes this calendar year."

ASB chief economist Nick Tuffley put the odds of another OCR rise next month at 60 per cent, followed by a pause until December.

Going up

• Reserve Bank yesterday raised the OCR by 25 basis points to 3.25 per cent.
• Forecast for 200 basis points rise by end of next year, of which 75 points has been delivered so far.
• Economists say another rise to 3.5 per cent next month is more likely than not.

See today's full Reserve Bank Monetary Policy Statement here: