NZ central bank, in neutral, will weigh drought, higher TWI in revising forecasts

The Reserve Bank will probably keep interest rates unchanged this week, reiterating that monetary policy is in neutral, while revising its forecasts to take in the impact of drought and a higher-than-expected trade-weighted index .

Governor Graeme Wheeler's statement on Thursday is expected to be broadly in line with that released on January 29, when he said headline inflation would probably stay below the bank's target 1-3% band in 2015 and could turn negative, while the official cash rate could be raised or lowered from 3.5% depending on the flow of economic data.

Mr Wheeler listed what he saw as the key risks to the New Zealand economy in a February 4 speech – uncertainties over China's economy, the price of dairy products, crude oil, houses and the exchange rate. Results have been mixed for those risks since then. China has lowered its 2015 economic growth target to about 7% from 7.5% in 2014, dairy prices have gained 11%, Brent crude is up 8%, data has shown the central bank's preferred house price measure rose 7.5% in January and the TWI is about 1.2% above the average level the bank assumed for the first quarter.

Mr Wheeler has a challenge in managing expectations for interest rates in the face of weak headline inflation that's driven by the slump in crude oil and the impact of a strong exchange rate. In turn, that is masking a more robust domestic economy benefiting from record migration, strong employment growth and the wealth effect of rising house prices.

"While no change in the OCR seems a given, the challenge for the bank will be to appear 'neutral' while forecasting low (possibly negative) inflation near term but rising underlying pressures medium term," UBS senior economist Robin Clements says. Mr Clements expects the central bank to hike the OCR by a quarter point in December, to reach a peak of 4.25% in mid-2016.

Oil, inflation and drought
Changes since the December 11 monetary policy statement are more pronounced. Brent crude has recovered from its lows of the year to trade recently at US$59.73 a barrel but is still some 45% down from a year ago and down from $US70 a barrel at the time of the December Monetary Policy Statement. Inflation fell in the fourth quarter, surprising the central bank, for an annual rate of just 0.8%.

The trade-weighted index was recently at 77.26 – above the average 76.3 the bank projected in the MPS for the first quarter and extending Kiwis' ability to source cheaper imports. Mr Wheeler is expected to reiterate that the currency's strength is unsustainable and unjustified.

Added to that is the impact of drought in the South Island, that while not yet of the scale of 2013's big dry, is drying off some dairy herds earlier than expected and is likely to see a lagged impact on primary production and more dairy cows and livestock are sent for processing, and farmers had into winter with less feed.

"The continuation of dry weather conditions through February means that the agriculture sector is likely to detract from measured real GDP growth in Q1 and Q2, largely due to lower output in the dairy sector," Deutsche Bank chief economist Darren Gibbs says.

Mr Gibbs expects the Reserve Bank's central projection in this week's MPS will be an unchanged OCR "well into late 2016," and said "a very modest policy tightening is likely to be projected" beyond that, contingent on the New Zealand dollar depreciating over time.

Traders see just a 4% chance of a rate cut in this week's MPS and 19 basis points of cuts in the next 12 months, based on the overnight index swap curve.

(BusinessDesk)