The start of 2023 has seen the economics teams at all the major New Zealand banks paring back their expectations for upcoming interest rate rises. Until this week, we had stuck to our view that the Reserve Bank would raise the official cash rate (OCR) by 75 basis points at its next review on 22 February. But the catastrophic effects of Cyclone Gabrielle have reluctantly tipped us towards a 50-point increase instead. This article sets out our assessment of the factors that are currently affecting the Reserve Bank’s thinking and influencing our view of monetary policy settings.

At this stage, the full extent of Cyclone Gabrielle’s damage and the associated costs are extremely unclear, but it looks likely to end up at well over $1b. Repair and rebuilding work will add to demand and, in tandem with supply chain disruptions and lost production, will probably have some inflationary effects. Given the current environment with already-heightened inflation, these additional pressures are bad news. However, these effects are likely to be temporary, and we would expect businesses to be as resistant as possible to raising prices and being seen to be profiting from the disaster.

The Reserve Bank’s response to previous “non-economic” shocks is also instructive. Following 9/11 in 2001, the Reserve Bank enacted an emergency 50-point cut to the OCR, and the 2011 Christchurch earthquake was also followed by a 50-point cut at the next review. On both occasions, broader economic conditions argued for easier monetary policy anyway. More recently, we’re well aware of the unprecedented easing in monetary conditions that took place when COVID-19 struck and New Zealand went into lockdown.

As a result, we expect the Bank to err on the side of caution at next week’s review, and lift the OCR by 50, rather than 75, basis points. In choosing a smaller rate rise, the Bank will be mindful of the optics of heaping more pain on affected households. The Bank is likely to note its ability to increase interest rates at subsequent reviews faster than might otherwise be the case.

It’s an uncomfortable balance – the Reserve Bank is focused on inflation and should be resistant to the influences and perceptions of changing monetary policy in the face of a natural disaster in a high-inflation environment. But the Bank took a cautious approach to the Delta Lockdown too, and if the Monetary Policy Committee were already tossing up between a 50- or 75-basis point increase, the uncertainty and perception of raising bigger on 22 February is likely to influence the Bank’s thinking.

We still think there’s a strong case for a 75-basis point increase, but the timing might make such a large call difficult to push over the line.

Most expectations at the end of 2022 were for the Reserve Bank to raise the OCR by 75 basis points in February 2023. However, data releases over the last month have seen most forecasters switch their expectations to a more modest hike next week of 50 basis points.

Various data releases have started to show important signs of a change of pace or direction across indicators. Core electronic card spending data fell 2.4% (seasonally adjusted) in December 2022, the first decline in spending in nine months, although spending rebounded 3.6% again in January. Job ads have pulled back sharply in December and January, monthly filled jobs recorded their first fall since March last year, and the NZIER’s Quarterly Survey of Business Opinion showed the lowest business confidence in half a century – but pricing and cost pressures remained high.

The two major recent data releases have been the Consumers Price Index and Labour Market Statistics for the December quarter. Inflation remains slightly below its June 2022 rate of 7.3%pa, but at 7.2%pa, it has only really plateaued, rather than showing any clear signs of starting to moderate.

Similarly, the labour market data showed a slight increase in the unemployment rate to 3.4% – up from the 3.2-3.3% of the previous five quarters, but not enough to convince us that the labour market is genuinely softening yet. Wage pressures intensified further, with the Labour Cost Index rising at its fastest pace ever (since records began for that measure in 1992). It’s worthwhile remembering that the unemployment rate remains well below the estimated sustainable rate of 4%, meaning that the labour market is still very tight and likely to be adding to inflation, rather than providing any cost or pricing relief.

The third major data release, GDP, is relatively old and was published before Christmas. Nevertheless, the 2.0% quarterly growth in September 2022 resulted in a level of economic activity that the Reserve Bank didn’t anticipate would occur until mid-2025 (see Chart 1). Thus the starting point for the economy is considerably higher, and the associated momentum substantially stronger, than the Reserve Bank was thinking in its November forecasts.

With the latest inflation result coming in below the Reserve Bank’s forecast of 7.5%pa and suggesting that inflation might have peaked, there’s some hope that the Reserve Bank could start to apply the brake to the economy a little less firmly.

The problem the Reserve Bank faces is that, even though inflation appears to have stabilised, it has stabilised well outside the Bank’s 1-3%pa target band. Yes, the December quarter lift in the Consumers Price Index (CPI) of 1.4% was smaller than the results in the previous quarters of 2022. But December typically has the smallest quarterly increases in the CPI anyway, averaging about 0.4 percentage points less than the September quarter and 0.2 percentage points less than March or June. And without the 7.2% quarterly decline in petrol prices, the CPI would have risen 1.8% over the quarter. Chart 2 demonstrates that inflation excluding petrol was still accelerating in the December quarter.

Hopes that inflation expectations might have peaked were also dashed in the December quarter, with the Reserve Bank’s Survey of Expectations showing one- and two-year-ahead expectations climbing to their highest levels since late 1990 or early 1991. Chart 3 shows that expectations for inflation in five or 10 years’ time from the Bank’s Survey have also continued to lift. ANZ’s Business Outlook and the NZIER’s Quarterly Survey of Business Opinion show a stabilisation in inflation expectations and cost or pricing expectations, but they remain at high levels, and there has been no meaningful improvement to date.

Part of the Reserve Bank’s job in setting interest rates is to ensure that monetary policy decisions are made in a forward-looking manner. If a recession is looming, or already underway, one might argue that the interest rate rises to date could bring inflation back under control over the next 18 months.

Although the Reserve Bank’s decisions during 2021 and the first half of 2022 arguably lacked enough of this forward-looking element, a smaller increase now would line up with the Bank’s dovish policy approach a year ago. It would also be consistent with a desire not to impose overly tight conditions in the face of disasters.

But a softer move would also be in complete opposition to the stronger line the Bank recently took, and could undermine the message to “cool the jets”. Bearing in mind the GDP data showing the economy is larger and, therefore, more stretched than the Reserve Bank had anticipated, the persistence of inflation and inflation expectations leaves little room for taking a softer monetary policy approach yet. A 50-point increase, rather than the 75-point lift implied in the forecasts in November’s Monetary Policy Statement, would mean the Bank runs the risk of failing to fully follow through on the expectations of higher interest rates it has created. That outcome could effectively lead to a loosening in monetary conditions.

Recent declines in fixed mortgage rates hint at the potential for financial markets to get ahead of the curve and loosen monetary conditions when the economy is still unbalanced, and inflationary pressures have not been fully quelled. These declines in mortgage rates appear to have been driven by a sizable fall in swap rates since late December, meaning that wholesale funding for banks has become cheaper, particularly at longer terms.

In addition, a smaller lift in the OCR next week could also be interpreted by markets that the Reserve Bank might follow up with fewer rate rises in coming months. It could send a message that the inflation outlook is less critical than the Bank had feared in November, and make the Bank’s previous forecast peak in the OCR of 5.5% by mid-2023 less likely to be reached.

Inflation and the general resilience of demand across the economy have tended to surprise so much on the upside throughout the last two years. As a result, a 50-point increase in the OCR risks the Reserve Bank taking longer to bring inflation back within its 1-3%pa target band. At this stage, there is little evidence that the economy is slowing, and even less evidence that inflation has started to be brought under control. A 50-point move might not be enough to keep squeezing consumer demand or disrupting business behaviour, which has got stuck in a pattern of passing on cost increases and putting up their prices.

However, in our view, the close call between a 50-point and a 75-point increase at next week’s Monetary Policy Review has been pushed towards the smaller lift by Cyclone Gabrielle. The full effects of the Bank’s interest rate rises to date have yet to be felt, and the cyclone has introduced another layer of uncertainty to near-term economic activity.