Mid-year cash rate rise likely

OPINION: Tomorrow morning the Reserve Bank will conduct its first review of monetary policy for 2010 and it is extremely unlikely that it will make any change to the record low 2.5 per cent official cash rate, writes Tony Alexander this week.

This cash rate is traditionally set by the RB at a level it feels will produce a level of interest rates (and maybe exchange rate) which will help keep inflation in a range between 1 per cent and 3 per cent around 18 months out.

The Reserve Bank aims that far out because influencing inflation in the short term is always difficult as inflation is usually driven largely by the degree of mismatch between demand for goods, services, raw materials and so on and the supplies of these things.

Imbalances can take a long time to change (unless we get shocks like the global financial crisis), so hard as it may be to pick what will happen 18 months or so down the track, the RB usually has a good length of time over which to influence demand in the economy in order to eventually affect prices – or maybe more accurately the pricing behaviour of those who supply the goods, services and resources.

At the moment there is generally no shortage of things in the economy – apart from housing. So currently inflationary pressures are low. But we can see clear signs that businesses are starting to hire more people. That means it is becoming reasonable to think about the excess supply of employable people drying up (unemployment falling) and therefore it becomes reasonable to think about wages growth accelerating – maybe two years from now.

We can also see that consumers are feeling happier and retail spending recently grew at its fastest pace in over two years. That means maybe some greater scope for retailers to put their prices up – but again, not now as one can tell clearly from the continuing hefty advertising of discounted products.

We can see that the world growth outlook has improved and our trading partners are expected to grow at an average to above average pace this year and next. That means rising global commodity/raw materials prices, which is what we have seen happen substantially in recent months. Higher input costs mean higher inflation.

We can also see house prices drifting back up again but what matters most with regard to general inflation is what rents will do and what will happen with building costs. Whatever the tax changes are for housing in the May budget, one can reasonably anticipate potentially firm upward pressure on rents as landlords seek to offset the tax change impact on their returns. And it seems reasonable to expect that construction costs will climb again as tradespeople soon start to leave for Australia or are lured into the rapidly expanding infrastructure sector.

None of these things or others we haven't mentioned bespeak of a bad inflation outlook over the next three or so years. So the need for punitive monetary policy is not established. By that we mean one cannot reasonably yet construct a scenario requiring the Reserve Bank to take the cash rate to the 8.25 per cent level reached in 2007. But equally one cannot reasonably any longer speak of a dire economic scenario requiring the record low interest rates forced on our central bank and banks overseas by the global financial crisis.

What is going to happen then is that starting from the middle of this year at the latest, the Reserve Bank will take away the unusually low cash rate and get things back towards neutral or more likely a tad above neutral come early 2012. That means the cash rate rising from 2.5 per cent toward 6 per cent.

That means people currently enjoying the lowest floating mortgage rates they have ever paid should budget for their floating rate rising about 3 per cent or more between the middle of this year and early 2012. After that – well frankly this far out it is anyone's guess.

 » Tony Alexander is the chief economist for the Bank of New Zealand.

- © Fairfax NZ News

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