The cost-of-living is about to get costlier with interest rates about to rise (again).

by Jarrod Kerr, Jeremy Couchman & Mary Jo Vergara

The RBNZ is set to lift the cash rate, again, by 50bps on Wednesday. The assertive move will see the cash rate hit a neutral setting of 2%. But there will be more rate hikes to come. The focus is on the RBNZ’s forecasts. We expect to see the OCR track pulled forward and shunted higher. We’re interested in the RBNZ’s thoughts around unemployment and inflation into 2023 and beyond.

The Government delivered its 2022 budget with a strong focus on health, climate and the cost-of-living. It was a fine balancing act... Rapid inflation means higher interest rates. It’s that simple. The focus this week turns sharply to the RBNZ. The RBNZ is widely expected to lift interest rates, again, by 50bps. The cash rate will most likely be lifted from 1.5% to 2% on Wednesday, and both lending rates and savings rates will follow. The RBNZ’s actions will only worsen the cost-of-living crisis faced by indebted households. But the RBNZ is tasked with keeping prices stable, and is mandated to keep inflation close to 2%. The problem is, inflation is running at 7%. And for a fierce inflation fighting central bank, not meeting the inflation mandate questions the bank’s credibility. So interest rates must rise to ensure inflation expectations remain well anchored.

Although much of the inflation we face is supply driven – with disrupted supply chains and supply driven surges in commodity prices – the RBNZ must rein in the demand side with the blunt tools at its disposal. And for the RBNZ, they want to make sure monetary policy is no longer accommodative, and soon to be contractionary. A cash rate of around 2% is deemed to be neutral – neither too loose (accommodative), or too tight (contractionary). Given the starting point for inflation, the RBNZ is hell-bent on getting the cash rate into contractionary territory. Hence a 50bp move on Wednesday is most likely. From there (2%),we expect to see the RBNZ slow down, a little, and revert to 25bp hikes into tighter territory. We expect to see the cash rate rise, in 25bp increments, to 3% by November. We suspect the RBNZ will stop around 3%. Why? Because the impact of every move to date, and from here, is causing a material impact on the housing market and household consumption. Cooling the housing market and taming consumption is the desired impact of rate hikes. And we’re forecasting house prices to fall by around 10% by year end. Consumption growth will wane as households face the negative wealth effect of falling house prices and a continued cost-of-living crisis. Of course, it’s easy to say that the risk of a recession rises with every rate hike. Recession risk is why we expect the RBNZ to pause at 3% - and not follow through with its forecast tightening in entirety.

Last week, the Government delivered its Budget 2022. The focus was directed at longer-term issues facing NZ (healthcare reform and climate change). But the headline grabbing announcements were aimed at alleviating the uncomfortable rise in the cost of living. A two-month extension to fuel excise tax cuts and public transport subsidies was granted. And a $1bn cost of living package was put together to support low-income households. However, these policies are no panacea for surging inflation. There is a deeper inflation issue at play. Budget 2022 may have been filled with big initiatives, but the question is whether it can deliver in increasingly difficult times? The Treasury’s latest forecasts for the Kiwi economy project more subdued growth, more persistent inflation and further tightening in the labour market. We run through the budget in a quick fix three chart summary below. The cost-of-living is about to get costlier with interest rates about to rise (again).

FIRST VIEW | MONDAY 23 MAY, 2022 All content is for information only, is subject to change and is not a substitute for commercial judgement or professional advice, which should be sought prior to entering any transaction. To the extent permitted by law Kiwibank disclaims liability or responsibility to any person for any direct or indirect loss or damage that may result from any act or omission by any person in relation to the material. Charts of the week: the RBNZ’s OCR track will give us a guide on where the cash rate is going. Rates markets are still overpriced. Getting into the nitty gritty of the MPS, the RBNZ’s OCR track will provide important insights. The OCR track is the RBNZ’s guide to future moves in the cash rate. And a lot has changed since the last track was published in February. Two 50bp hikes are likely to have been delivered, an acceleration from the last February MPS. The “stitch in time” approach is designed to front load hikes, in order to do less later. The OCR track will have been pulled forward, to take account of the two 50bp moves, and pushed higher. Although we don’t expect the end point to be materially higher, given the “stitch in time” approach. We expect to see the end point lift from 3.35% to 3.5%. If we’re right, wholesale markets have too much in the way of hikes priced. The terminal rate implied in interest rate markets is closer to 4%. We expect to see a slight rally in rates, lower yields, as the market realises fewer hikes are likely. Indeed, we are still forecasting a terminal rate of 3% in this cycle. We believe the RBNZ is already getting bang for buck with mortgage rates already reflecting an aggressive tightening in policy from here. We’re forecasting the RBNZ to move back to 25bp moves beyond this Wednesday, and a 3% cash rate by November. Come November, the housing market is likely to have experienced a 10% decline in prices.

The negative wealth effect will have dampened consumption, and the cost-of-living crisis is likely to be lingering. We suspect a move to 3% will be enough to turn the Kiwi economy and tame the inflation beast. We simply think the economy will struggle with aggressive tightening to 3.5% and beyond. Mortgage rates are rising, and will rise further with expected RBNZ tightening. All mortgage rates on offer are likely to lift from the current levels of between 4.4% to 6.9%, to 6% to 7.5% over the coming year. More than 60% of outstanding mortgages are either floating, or rolling off fixed rates this year. The impact of the RBNZ’s tightening is being felt now and will continue to weigh on household budgets in the year ahead.

Financial Markets The comments below were provided by Kiwibank traders. Trader comments may not reflect the view of the research team. In rates, all eyes are on the RBNZ: “The transition from high inflation to weaker growth expectations has been swift, as has the reversal in yields. Lockdowns in China, Ukraine, aggressive central banks tightening all to blame. In saying that NZ yields have found a temporary base ahead of this week’s all-important RBNZ MPS, with end point OIS expectations hovering just under the 4.00% mark by 2023. Most expect the Feb RBNZ OCR endpoint to be revised mildly higher, consensus settling around 3.50% given the lower TWI. In addition, the RBNZ need to add another quarter to their forecasts to June 2025, and that’s where things get interesting as there is potential for the RBNZ to forecast an OCR cut if their forecasts dictate. Regardless of this there continues to be a liquidity premium priced into the Kiwi rates curve, meaning liquidity has been The Budget in three charts. A key focus of last week’s Budget was the uncomfortably high cost of living. The Government had to walk the fine line between boosting spending to tackle policy issues and exacerbating domestic inflation. More relief was provided to households via extensions to the recent transport package and new cost-of-living payments. In addition, the Government spent up large on health reform. Treasury’s fiscal impulse analysis suggests that the fiscal spend up won’t contribute any more expansionary momentum that has already been delivered to fight covid. The fiscal projections presented by Treasury were weaker overall compared to six months ago. The operating deficit experiences a deeper trough and net debt a larger peak. The expected tax take has been upgraded. However, surging costs means that to deliver the same quantity of services, the Crown needs to spend more. As a result, the rise in crown expenses outstrips growth in tax revenue over the next few years at least. The Government stuck closely to Budget 22’s planned $6bn increase in baseline spending. From the 2024 fiscal year, the Crown accounts generally improve with operating surpluses expected from 2025. Covid-related emergency spending (temporary) is wound up. The Government has also bumped up Budget 2023’s operating allowance to $4.5bn. And moving away from tradition, has already committed almost $2bn of next year’s budget as part of a new “multi-year funding approach”. According to the Treasury, the Kiwi economy is expected to rebound following the Omicron disruption. But beyond that, a slowdown in economic activity is expected. Because the intense difficulty in finding staff and materials means it’s getting harder and increasingly expensive to eke out further growth. A significant weakening in household demand too is expected to contribute to the slowdown as rising interest rates and rising prices stretch budgets. Compared to the HYEFU 2021, the tweaks to Treasury’s main eco forecasts suggest: more subdued growth, more persistent inflation, and further tightening in the labour market.

FIRST VIEW | MONDAY 23 MAY, 2022 Atrocious albeit improving over the past couple of weeks. Boiling that down there is room for downside to Kiwi rates, with the curve steepening and flattening on the global central bank outlook. The benchmark 2-year swap rate can easily fall back to around 3.30% if the RBNZ is unequivocally convincing in its message i.e. 3.50% end point, transition to +25bp, cut in mid-2025. It does feel now that once five-year interest rate cycles have compressed to three, this is one of the (many) issues with bigger cuts and hikes overlaid with QE that traditional economic timings don’t apply. Expect a +50bp hike from the RBNZ on Wednesday with open ended guidance on moving from +50bp hikes to +25bp hikes, the OCR track may keep a +10bp premium in there for a +50bp hike i.e. 3.10% OCR forecast for year-end (current market at 3.25%). It’s all about engineering a softer landing, which is more art than science at this juncture.” Ross Weston, Senior Portfolio Manager.

In currencies, Has the tide turned? “Pushing against a broader decline in risk sentiment across markets, the NZ Dollar put in its best weekly performance since early March - gaining by over 2% versus the US Dollar and taking out the silver medal place across the major G- 10 currency basket for the week. Despite continued hawkish Fed speak, including Chair Jerome Powell commenting that there will be no hesitation to take the Fed funds rate well above its neutral level in order to see a “clear and convincing” decline in inflation pressures, in perhaps an early sign of mission fatigue, investors instead chose to take profit on long US Dollar positioning. With over 190bp of expected Fed hikes priced by December - an average of 38bp of hikes per meeting, and effectively 100bp priced of over the next two upcoming meetings, the market is now assessing the eventual need for a follow-up 50bp hike in September. Whilst May’s US inflation print provided the slightest hint that inflation pressures may have perhaps peaked in the US, the next 2-3 upcoming sets of data will provide clarity on the Fed’s roadmap beyond July, and with it, likely determining whether the recent one-way US Dollar story can take the Kiwi further below its recent lows. Furthermore, hawkish developments across other major central banks including the ECB, BOE and now even possibly the BOJ, who will be now reviewing Friday’s Japanese April annualised inflation print of 2.5%, may start to see a potential rebalancing effect out of the US Dollar. As the ECB at least lines up its first-rate hike in over 10 years in July, the risk / reward dynamics have now arguably started to support NZDUSD strength once more. Of course, this same dynamic may bring weakness to NZDEUR and NZDJPY with it. This week attention turns to the RBNZ’s MPS for NZ Dollar market participants. Other than a highly surprising 25bp or 75bp rate move on Thursday, market attention will be focused on clues as to RBNZ plans for July’s MPR its update the expected terminal level within the OCR track. Purely from a currency effect on inflation perspective, and given the above thoughts on the US Dollar, now is not the time to blink for the RBNZ. With OIS pricing across the past week or so rallying back more arguably ‘neutral’ levels, reflecting a terminal OCR level of 3.71% and a further 37bp of hikes in July, the opportunity has been presented to the RBNZ to press home the front loading of rate hikes and with it, supporting the tentative NZ Dollar recovery of the past week. A hawkish statement could see the Kiwi back above 65 cents once more and in turn, helping the RBNZ in its inflation slaying mission as importers patiently wait for improved hedging levels.

Technically, the early May low at circa 0.6220, holding onto the significantly important 61.8% (0.5470 – 0.7465) retracement level remains key for NZDUSD bears. On the upside, immediate resistance has developed in the 0.6410/20 area across the past couple of days. Importantly for NZDUSD bullish momentum, this area also remains key for further upside moves on a technical basis with it also coinciding with the broader recent downtrend resistance zone. Daily momentum indicators also support upside NZDUSD moves with the 14-day RSI now broken out its March downtrend, but still also sitting below neutral levels. So, whilst NZDUSD holds below 0.6420 the previously commented 0.6230 – 0.6400 range remains in place however this week’s RBNZ event may likely prove to be the determinant from here. A break to the upside then opens up the mid 65 cent zone in the first instance.” Hamish Wilkinson, Dealer – Financial Markets. Weekly CalendarDate Economic Indicator Last Consenus Comment Mon, May 23 AU RBA Speaker - Kent - - UK BoE Speaker - Bailey - - GE May IFO Expectations Index 86.7 86.5 The war in Ukraine looks to have delayed the recovery from omicron in Germany. The expectations measure of the Ifo survey is picked to fall further in May. That doesn't bode well for GDP growth.

Retail sales data for the March quarter will set the mood ahead of the release of Q1 GDP data next month. In the face of the wave of omicron infections, and surging petrol prices, growth in retail sales volumes likely nosedived at the start of 2022. The market is picking a mute 0.3% gain in the quarter. A contraction in sales volumes can't be ruled out.