New Zealand's confidence increases

Westpac is forecasting the cash rate to increase by almost 3 percentage points by the end of 2016.

The New Zealand economy is rumbling along at a decent clip. GDP grew 2.7 per cent over 2013 despite a severe drought early in the year. All indications are that without such a disruption this year, growth will accelerate further to about 4 per cent.

And it's not just economists who think prospects are improving. Business and consumers are more optimistic about the economic outlook than they have been in years, if not decades.

The Canterbury rebuild remains a key driver of growth but it is by no means the only one. A lift in construction activity in Auckland, freer consumer spending following the recent period of strong house price growth and, most notably for the rural sector, a four-decade high in the terms of trade, are all playing important roles.

Unsurprisingly, strong export commodity prices and favourable climatic conditions in many (though not all) regions is boosting incomes and confidence in the rural sector. Rural land prices have been tracking higher and turnover has risen. In the latest Westpac McDermott Miller consumer confidence survey, while rural households reported that their financial situation continues to steadily improve, they have become less willing to spend a windfall or to buy major household items.

With activity increasing strongly and firms optimistic about the future, they have become more willing to hire new workers, businesses and invest in new equipment. And they are starting to have price increases in their sights. Surveyed measures of pricing intentions have notably picked up, adding to inflation pressure in the economy. The Reserve Bank expects inflation to hit its 2 per cent target by the middle of this year.

So, after sitting after sitting on the sidelines for the last three years, the Reserve Bank recently entered the fray again, raising the OCR by 25 basis points to 2.75 per cent in March, and signalling it has a lot more work to do yet.

The move certainly shouldn't have come as a great surprise to most interested observers, farmers or mortgage holders. The Reserve Bank has done everything it possibly could to warn the both the NZ public and financial markets that higher interest rates were on their way.

Consequently, while stories of 'mortgage pain' and 'savers' gain' may have hogged the headlines for a day or two, there was actually a relatively muted reaction to the announcement in markets. And that's exactly the way the Reserve Bank will have liked it. With Graeme Wheeler at the helm, the Bank has been at pains to be as open and transparent as possible - a tactic which should help them avoid some of the political crossfire in an election year where the monetary policy framework is sure to be a topic of debate.

The Reserve Bank's latest forecasts suggest it plans to raise interest rates a further 1 percentage point in 2014, which doesn't leave much time for dilly-dallying. We think the Bank will be raising the OCR by 25 basis points at each of its next three meetings (April, June, and July) before pausing to assess how the economy is responding (after all the NZ economy hasn't had to deal with rising interest for quite some time!). But the tightening cycle won't end there.

We're forecasting the cash rate to increase by around 3 percentage points by the end of 2016.