Reserve Bank hikes official cash rate to 2% and plots course to 4% next year

Wednesday, 25 May 2022

“Without doubt, we need to slow the growth in demand,” says Reserve Bank governor Adrian Orr.

Reserve Bank governor Adrian Orr has plotted a course to much higher interest rates, despite acknowledging the risk of a recession.

The central bank raised the official cash rate (OCR) to 2%, from 1.5%, on Wednesday in a bid to drive down inflation which is currently running at a 31-year high.

It also significantly increased its forecast of how high the OCR might rise over the next three years.

The Reserve Bank is now predicting the rate will need to climb to about 3.4% by the end of this year, peaking at 3.9% from June next year.

As the bank tends to move the OCR in increments of 25 basis points, that implies a high chance of the rate topping out at 4%.

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The 50 basis point move means the OCR is now at its highest level since 2016.

The size of the forecast increase in future rates appeared to surprise the market and could filter through quickly into longer term fixed mortgage rates.

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ASB chief economist Nick Tuffley said it had thought the Reserve Bank “would come out swinging” but its statement was still more hawkish than expected.

“The Reserve Bank’s new OCR forecast profile implies both a higher OCR peak than we had expected and a more rapid pace of tightening to get there,” Tuffley said.

Prior to Wednesday’s monetary policy statement, the Reserve Bank had been forecasting the OCR would stay below 3% until mid next year and peak at about 3.4% in 2024.

A silver-lining for mortgagees is that the Reserve Bank now sees light at the end the tunnel and is forecasting the OCR will start falling towards the end of 2024.

It expects house prices will fall 14% from their November peak, by 2024, with about a third of the decline having already occurred.

The Reserve Bank is forecasting the economy will keep growing every quarter but Orr said a recession “sat within a range of possible outcomes, of course it does”.

The Reserve Bank said government spending was contributing to “a modest increase in demand” and Adrian Orr further downplayed that as “relatively small beer” during a media conference.

Explaining its decision to dish out the monetary medicine despite that risk, Orr emphasised how difficult it would be to rein back inflation, if inflationary expectations got away on the bank.

“Without doubt, we need to slow the growth in demand until it is better aligned with the ability to supply that demand. In the absence of that, inflation will keep going higher.”

Heightened global economic uncertainty and higher inflation were dampening global and domestic consumer confidence, the Reserve Bank said in its statement.

“Asset prices, in particular house prices, have also declined, reflecting in part higher mortgage interest rates and increased supply of housing,” it said.

National Party finance spokesperson Nicola Willis was quick to shift the focus of the Reserve Bank’s statement on to government spending.

But it said “underlying strength” remained in the New Zealand economy, “supported by a strong labour market, sound household balance sheets, continued fiscal support and strong terms of trade”.

The Reserve Bank is forecasting annual inflation will reduce to 4.4% by March next year and drop to 2.5%, within its target band, a year after that, but it is forecasting unemployment will rise gradually to 4.7% by March 2025.

It said government spending was “contributing to a modest increase in demand” but tempered that message by saying that stimulus was expected to reduce in coming years.

National Party finance spokesperson Nicola Willis said rising interest rates would be difficult for people battling “the cost of living crisis”.

“We have known since last year – well before the Russian invasion of Ukraine – that New Zealand had an inflation problem but the Government’s only response has been to put more fuel on the fire with more spending,” she said.

“Now the Reserve Bank has no choice but to increase the OCR, pushing up interest rates across the whole economy and creating more pain for mortgage holders.”

Orr denied last week’s Budget, which included a $350 cost of living payment for low and middle income earners, was a trigger point for the bank’s decisions on Wednesday.

“What we saw from the Budget last week is an upward tick in demand pressure coming from government in the near term – more than we anticipated from their half year economic forecasts – but relatively small beer compared with all the other drivers that are going on,” he said.

The Reserve Bank’s tough monetary policy statement had an immediate impact on financial markets, with the New Zealand dollar gaining about 0.5 US cents to trade at US64.8c.

Capital Economics economist Ben Udy said the bank sounded “hawkish” in its Wednesday statement but emphasised the fact it now saw rates falling towards the end of its three-year forecast period.

“We have been forecasting that this housing downturn would force the Reserve Bank to reverse course and cut rates in 2023,” he said.

“Admittedly, its forecasts have rate cuts pencilled in for 2024, a little later than our own forecast. But the key point is that the bank is now forecasting rate cuts and we suspect market pricing and the analyst consensus won’t be far behind,” he said.