The prognosis for interest rates

On Thursday (the 24th) the Reserve Bank will make its six-weekly announcement regarding interest rates. Most economists expect the Official Cash Rate (OCR) rate to increase by 0.25% to 3.5%. That would be the fourth successive 0.25% increase since rates starting rising from a historic low of 2.5% in March.

However, there is less agreement about when the next interest rate rise is likely to take place. Some economist are speculating that next week’s interest rate rise may be the last for the year. They cite a number of reasons, but two in particular.

The first is the sharp fall in international dairy prices, which were down another 8.9% in Fonterra’s 15 July Global Dairy Trade auction. Prices are down a third since January this year, which represents a major ‘correction’ in anyone’s language.

Fonterra will not be advising the effect this will have on the dairy payout until late July or early August, but most dairy watchers are expecting the current years projected payout of $8.40 per kg of milk solid to fall to around $6.25 next year. That would wipe just under $4 billion off farmer incomes, and about four times that amount from provincial economies when the multiplier (circular flow) effect is taken into account. What impact this will have on rural land prices is uncertain at this stage; that will depend on how far global dairy prices fall and how long they take to recover. China currently takes about 20% of our dairy output. The general chatter is that China had been stockpiling product and are now consuming from that inventory rather than buying on the spot market. Presumably when that stockpile is run down the Chinese will be back in the market.

The dilemma the Reserve Bank has is the exchange rate. At 3.5% our OCR would be 3% higher than central banks in the US, Japan and Europe, and 1% higher than Australia. That positive arbitrage creates demand, which inflates the kiwi dollar so the goods we buy from overseas are cheaper than would otherwise be the case (like petrol) while our exporters like Fonterra (i.e. farmers) receive less. Holding the OCR at 3.5% for the remainder of the year may give some time for our exchange rate to ease.

The second reason why economists think interest rates will remain on hold through to the end of 2014 is Auckland – property prices are slowing. The fast-tracking of consents has freed up the regulatory bottleneck and there is the prospect that for the first time in many years the supply of new homes coming onto the market will outpace demand.

So watch out for this weeks OCR announcement, in particular the comments from Governor Graeme Wheeler that go with it.

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