Economy improves but rate rise likely

IGHT TIMES: Reserve Bank Governor Graeme Wheeler is expected to kick off a substantial tightening cycle soon, that will run until 2016.

A quick scan around the regions finds many in the rural sector in good heart at the start of 2014.

Timely rainfalls so far this summer have kept pastures in good condition across large swathes of the country, farm gate prices for most products range from good to outstanding and optimism in the sector is riding high.

Such a buoyant mood is no small achievement following the rollercoaster ride of 2013 _ a year marked by both the best of times and the worst of times for many farmers.

So just what might 2014 hold in store? Undoubtedly there will be surprises (though hopefully not of the drought, food contamination or earthquake variety!). But those in the rural sector would be well advised to prepare for some of the more predictable elements of 2014.

While commodity prices should remain relatively high this year, we don't think they can be sustained at the current exceptional levels.

Demand from China may be strong but prices are still likely to soften a little as global supplies of key commodities such as dairy increase.

The high prices currently on offer provide a strong incentive for producers around the world to lift output and the increased supply should put downward pressure on prices.

China has become increasingly important to New Zealand exporters in recent years. In November, it kicked Australia off its perch as our number one merchandise export destination.

It was already our biggest source of imports. And given the scale of opportunities this market offers New Zealand exporters, this trend is unlikely to reverse any time soon.

New Zealand's rural sector should benefit from ongoing efforts by the Chinese administration to reorientate spending away from investment, toward consumption.

And although growth in the Chinese economy is expected to slow a little further this year, ongoing changes in the structure of the economy (such as urbanisation, growing wealth of consumers, evolving tastes and preferences) mean Chinese consumers are likely to continue to demand more of the commodities New Zealand has to offer.

Robust commodity prices are one important reason we expect the NZ dollar to remain above 80 cents against the USD in 2014. Another factor which will support the NZ dollar against our key trading partners is the outlook for local interest rates.

The evidence is now clear that the New Zealand economy is starting to hit its straps. The rebuild in Canterbury is steaming ahead and driving growth in the construction sector. Businesses and households are more confident about the future than they have been in years, and this is beginning to flow through to hiring and investment decisions and a pickup in consumer spending.

In such an environment the economy no longer needs support from record low interest rates.

We expect to see the Reserve Bank kick off a substantial tightening cycle soon - one that will see them lift interest rates significantly higher this year and next.

In fact we believe the Reserve Bank will continue hiking interest rates until 2016, when we expect the OCR to reach 5.5 per cent - that's a long way north of the 2.5 per cent it has been for the last three years.

So what does this mean for people deciding between fixed and floating interest rates? Right now, fixed term interest rates are roughly consistent with our view of where the OCR is headed over the next few years, making us indifferent between fixing and floating. But markets are notorious for overshooting.

Should they get ahead of themselves (and anticipate a larger hiking cycle than we think likely) then fixed interest rates might rise above where they are now for a period.

That means for people looking to fix interest costs for risk management reasons, it could be better to do this now rather than later.