It’s a longer than usual gap between Monetary Policy Statements. With few significant data releases before the September  review, the market took what it could from the RBNZ Governor’s speech last week.

The RBNZ still sees the economy in recovery mode, even though growth is not expected to be outstanding and the  downside risks are all too apparent. Annual inflation has been steady around the middle of the 1-3% target band so far in  the recovery. However, as economic activity returns to its potential, inflation pressures are expected to build again and  rates will need to be normalised.

The inflation picture for the next year or so will be complicated by a range of government policy-related price increases,  which will see annual inflation approach 5% by the middle of next year. The RBNZ has scope to look through these  one-off effects on the price level,  but there is the danger that higher inflation comes to be seen as the norm, and filters  through into wage and price setting (note that this will be the third breach of the top of the target band in five years). The  RBNZ is “hopeful” that it won’t need to raise rates to lean against a ratcheting-up of inflation pressures, but it will continue  o monitor the situation, and warned businesses and other groups against pushing through additional price  hikes under the cover of the upcoming GST hike.

For the most part, the speech was arepeat of what the RBNZ has already said in recent statements. However, it did  emphasise that the RBNZ is giving the benefit of the doubt that higher inflation expectations won’t be acted upon in  wages and prices. That seems to imply a demotion of Tuesday’s inflation expectations survey as a useful inflation indicator. The previous quarter’s surveysaw expectations rise to 2.8% for two years ahead (which is beyond the direct impact of most of the impending policy changes), and we wouldn’t be surprised if it heads a little higher.

Wholesale interest rates fell after the speech
With the market apparently reading it as a signal that the RBNZ  s reluctant  o raise the OCR further. Given the global backdrop lately, it’s not surprising that the market would be looking for the  downside risks in everything, but even so that conclusion seems a bit of a stretch.

The RBNZ’s forecast for inflation to remain “comfortably inside the target band in the second half of our forecast horizon”  is a conditional one, which relies on the RBNZ delivering the rate hikes that they have projected. In the June MPS those  projections pointed to a peak OCR of close to 6%; the July review hinted at something less. But we would be staggered  if the RBNZ has taken its projections down to anything like the 4% peak that the market is now pricing. An extended series of rate hikes is still the base case; the message of the speech was that the RBNZ doesn’t want to have to raise  rates even more than it has already flagged.

On the data front
Net migration inflows rebounded to a seasonally adjusted 970 in July, the highest since March. We had been puzzled by the weakness of foreign arrivals in recent months, and while the bounce in July was a pleasant change,  it simply serves to highlight the volatility of this series. There was also a sharp drop in the number of Kiwis heading overseas, though we don’t think this marks a change in the trend. The strong Australian labour market will continue to draw Kiwis across the Tasman in coming months, keeping overall net migration at a lower level than in previous cycles. 

Visitor arrivals rose a seasonally adjusted 1.4% rise in July, taking the annual total above 2.5 million for the first time. In contrast, short-term departures of NZ  esidents fell 1.0%, continuing the theme of subdued spending by NZ households.

Producer prices recorded another large gain in Q2, with inputs up 1.4% and outputs up 1.1%. The new information content in this release is limited, not just because it comes a month later than consumer prices, but because the drivers are already well recognised: higher world prices for our key commodity exports such as milk, meat, wood and oil. The implications for general inflation are limited – these items are a tiny fraction of NZ consumers’ spending, while they make  up a large proportion of our production. Low CPI inflation and high PPI inflation simply reflects a relative price  shift, albeit one that bodes well for NZ’s near-term economic outlook.

Finally, on Friday Fonterra said that it is maintaining its payout forecast for the current season of $6.90-7.10/kg – a relief  given recent speculation that it may be lowered. That said, if world prices and the NZ dollar remain around current levels  for the rest of the season, the risks to the payout are now to the downside (whereas they were substantially to the upside  just a few months ago). However, Fonterra sees scope for prices to improve later in the season.

Our own view is that dairy prices will stabilise or improve over the next few months, but a bumper Australasian growing  season will eventually weigh on prices. However, our difference in view amounts to a tradeoff between prices and  volumes. We expect dairy farmers’ incomes in the 2010/11 season to be within $500m of the $9.8bn achieved in the  record 2007/08 season.

Fixed vs. floating:
The gap between fixed and floating rates has narrowed significantly – partly because financial markets are questioning  the RBNZ’s resolve to return the OCR to normal levels. Borrowers who believe that the economy is simply wobbling  along the path to recovery, and therefore that the RBNZ will continue to normalise the OCR in the next few years, will find  today’s 2-3 year fixed rates very attractive. Those who believe that markets are presaging a return to recession will be  more attracted to floating rates.

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Previous Westpac Weekly Commentary
Westpac Weekly Commentary 09 August 2010 >>
Westpac Weekly Commentary 02 August 2010 >>
Westpac Weekly Commentary 19 July 2010 >>
Westpac Weekly Commentary 12 July 2010 >>