The RBNZ prepares to kick-off a lengthy tightening cycle

The Reserve Bank of New Zealand is expected to kick-off a prolonged tightening cycle this week by increasing the official cash rate by 25bps to 2.75% (the announcement is due at 2000GMT tomorrow). This represents a significant turning point in monetary policy in NZ. The RBNZ has kept the official cash rate steady at 2.5% for three years in an attempt to stimulate the economy and spur growth. Now, rising house prices are driving up inflation and earthquake reconstruction efforts are providing a solid platform for GDP growth.

Since the bank last met economic data has been broadly positive. Business confidence and NZ’s terms of trade continue to soar, consumer confidence remains very high, retail sales have picked up, and the unemployment rate dropped to 6.0% (from 6.2%) last quarter. Q4’s employment report was particularly positive because it showed a 1.1% increase in employment over the quarter, almost double what the market was expecting. While there has been some hesitation from consumers to spend, there are signs that they should start losing their purse strings, including increasing incomes. Overall, the NZ economy appears to be powering ahead and dealing with the recent strength of the kiwi pretty well.

Last year the NZ dollar acted as a natural handbrake to monetary policy expectations in NZ, but a high terms-of-trade seems to justify the position of the commodity currency now. Also, the strength of the NZ economy and global economic conditions have made the kiwi a more attractive investment than it otherwise would be. Hence, the RBNZ may have to accept the strength of the kiwi for the moment, and high dairy prices are offsetting some of the negative implications of a strong exchange rate.

Overall, the threat of rising inflation and the strength of the NZ economy make it very likely that the RBNZ will raise the official cash rate at its meeting on Thursday. In fact, there is even the possibility, albeit a remote one, that the RBNZ will raise the official cash rate by 50bps, as opposed to just 25bps. We think this more likely than the bank not doing anything, but it’s still somewhat of a longshot. After all, the bank is concerned about the value of the kiwi and doesn’t want to risk looking more hawkish than necessary.

Market impact: NZD

There are three key scenarios which may emerge from this week’s policy meeting. Firstly, and most likely, if the bank cuts the official cash rate by 25bps, the direct impact on the kiwi is likely to be fairly limited because it looks be fully priced in. In this case, all eyes will be on the press conference (2005 GMT) and the MPS that accompany the rates decision, and especially the bank’s intended path for the official cash rate – look at the MPS. The other less likely possibilities are that the bank hikes the official cash rate by 50bps or it leaves interest rates on hold at 2.5%, in which case the kiwi would likely rally on the former scenario and sell-off on the latter scenario. If the bank does elect to leave monetary policy alone this time around, NZDUSD could quickly erase a significant proportion of its recent gains.