The RBNZ is expected to hike rates, before shifting into neutral

The Reserve Bank of New Zealand (RBNZ) is expected to hike the official cash rate to 3.5% from 3.25% at its policy meeting on Thursday. The bank has increased the cash rate at its last three meetings in response to strong non-tradables inflation and robust growth, which has put the RBNZ on the path towards normalising monetary policy. However, falling commodity prices, particularly for milk and logs, and a stubbornly strong NZ dollar have cast doubt over RBNZ Governor Wheeler’s planned tightening cycle.

The RBNZ to change gear

The market expects the bank to shift into neutral for at least a few months after tomorrow’s meeting. This possible change of tone at the RBNZ, to be expressed in Wheeler’s statement which accompanies the bank’s rate decision, may come in the form of putting more emphasis on future economic data. In other words, the RBNZ may signal that it needs to assess more economic data to better determine the path of future interest rate hikes, especially in the face of a strong exchange rate and weakening commodity prices.

The kiwi has softened a little already

The RBNZ has continuously expressed concern about the strength of the NZ dollar amidst falling commodity prices. And while the kiwi has softened recently, it may not be enough to appease NZ’s central bank. As long as the kiwi remains elevated it puts downward pressure on tradables inflation and impedes growth in NZ’s all-important export sector.

Last quarter, consumer prices rose less than expected (0.3% q/q vs. 0.4%) which gives the RBNZ some room to pause it’s tightening cycle and wait for more economic data to better assess the real strength of inflation. However, the RBNZ was the first central bank amongst its counterparts in the G10 to raise interest rates for a reason. Reconstruction efforts are spurring prices for construction goods and net immigration is adding more pressure to NZ’s housing sector. While house price growth has moderated lately, it’s still putting upward pressure on non-tradables inflation. Overall, it’s unlikely that the RBNZ will completely drop its tightening bias at tomorrow’s meeting, but we do expect the bank to sound significantly less hawkish.

Tomorrow’s meeting may be crucial for the near-term direction of the kiwi. Given the likelihood that the RBNZ will raise the official cash rate while sounding more neutral about the prospects of future rate hikes, the risk appears to be to the downside for the kiwi at first glance. But the market has largely priced in this scenario, thus we think the risk comes from the RBNZ sounding more hawkish than the market expects, although this isn’t our base case. (For a look at NZDUSD see Kathleen Brook’s report: Time to get interested in NZDUSD?)