UPDATED: Wheeler keeps rate hikes on table even with softer outlook; Kiwi jumps

UPDATED 10am: Reserve Bank governor Graeme Wheeler said he's likely to continue raising interest rates even in the face of a softer economic outlook, surprising economists who had expected a more dovish statement and driving up the kiwi dollar.

“Modest inflation pressures suggest the expansion can be sustained for longer than previously expected with a more gradual increase in interest rates,” Wheeler said in today's monetary policy statement, where he held the official cash rate unchanged at 3.5 percent as expected. “Some further increase in the OCR is expected to be required at a later stage.”

The New Zealand dollar jumped as high as 78.25 US cents, from 76.85 cents immediately before the 9am statement, and was recently trading at 78.10 cents.

The central bank "reinforced its explicit tightening bias - a hawkish surprise to the markets," said Imre Speizer, strategist at Westpac Banking Corp.

Wheeler lowered the track for the 90-day bank bills, seen as a proxy for the OCR, by 30 basis points, adding to the 0.5 of a percentage reduction by which the bank lowered its expectations in September. The central bank also trimmed its forecast for gross domestic product in the year ending March 31, 2015, to 3.5 percent from the 3.6 percent rate seen three months ago. Despite the softer track, currency traders said the central bank's assessment showed the New Zealand economy was relatively robust compared to other major economies.

"Despite the obvious risks that they have noted, it still looks like a very rosy outlook when you take it from a global perspective and that has led to the currency increasing," said ANZ Bank New Zealand senior foreign exchange strategist Sam Tuck. For overseas investors, New Zealand "looks like a pretty decent place to put your money" he said. "It's that relative dynamic."

The Reserve Bank raised its expectations for GDP expansion in 2016 and 2017 to 3.1 percent in both years, having previously projected annual growth of 2.7 percent and 2.3 percent.

The pace and timing of future hikes will depend on how the economy has responded to the 100 basis points of increases earlier this year, with three important considerations being how pricing decisions interact with capacity pressures and inflation, how house price inflation develops and how lower dairy incomes affect spending, the bank said.

.In July, Wheeler signalled a pause in the bank’s current tightening cycle, saying the bank needed to take "some time" as “a period of assessment” was needed to gauge the impact of the four rate hikes this year. At last month’s review he dropped the reference that "further tightening will be necessary to keep inflation near the 2 percent target."

The bank has been surprised by the country’s tepid pace of inflation, which slowed to an annual 1 percent rate in the September quarter as a resilient kiwi dollar continues to keep imports cheap, while increased construction activity in Christchurch and Auckland fails to spill-over into broader consumer price rises.

Wheeler said the strong exchange rate, falling oil prices and more subdued non-tradable inflation was the cause of soft inflation, and the bank expects that slow pace to persist through the first half of 2015 before creeping higher. Tradable inflation also faces a short-term downside risk, with oil prices falling below the bank's assumed range when it set the forecasts for today's report.

"The falls in oil prices since the finalisation of the forecasts, and the potential for further falls over the remainder of 2014, pose downside risk to tradables inflation over the December and March quarters," the bank said.

Still, that modest pace of inflation means the country's economic growth can be sustained for longer as households lift consumption and the Canterbury rebuild and buoyant property markets stoke construction activity.

Fonterra Cooperative Group [NZX: FCG] yesterday cut its forecast payout to farmers, which economists estimate will reduce their income by more than $6 billion from last year, when they enjoyed a record payout.

Wheeler said the currency remained "unjustifiably and unsustainably high" and that the bank expects "a further significant depreciation," even after its recent weakness as global investors flock to the greenback in anticipation of the Federal Reserve moving away from its zero interest rate policy next year. The bank noted that while the trade-weighted index was largely unchanged in the quarter, there had been a divergence on the cross rates where the kiwi weakened against the greenback, while strengthening against the yen and Australian dollar.

The kiwi fell to a two-and-a-half year low against the greenback earlier this week, though it has held up on the other cross-rates.

The Reserve Bank expects the trade-weighted index to trade at an average 77.5 in the December quarter of this year falling to 74.8 by the end of 2015, having previously seen it fall to an average 78.4 over the December quarter and dropping to 75.8 by the end of next year.

(BusinessDesk)