Mark Lister: Reserve Bank takes everybody by surprise

The Reserve Bank expects the NZ dollar to gradually depreciate.

By my reckoning, the Reserve Bank's 39-page September Monetary Policy Statement (MPS) was 15,615 words long. Recognising that others don't find this publication the intriguing read we do, I have attempted to condense what we believe are the key points.

The most controversial and talked-about aspect of the document was the size of the cuts the bank made to its economic growth forecasts.

While most pundits had already trimmed their forecasts following the slew of uninspiring economic data over recent weeks, nobody was expecting the RBNZ to slash its 2011 GDP growth figure by 1.3 per cent, to 2.5 per cent. The bank is now forecasting growth to be just 2.6 per cent this year and 2.8 per cent in 2012.

Its reasons for taking the chainsaw to its growth forecasts are lower household consumption, an uncertain outlook for export prices and a mixed outlook for key export markets such as the US.

However, one issue appears to dominate - "deleveraging", or the process of paying down debt. Household debt ballooned over the boom years but now, with house prices no longer rising, must be paid back out of cash flow, rather than capital gains.

This leads to lower consumption as cash is applied to reducing debt rather than going on spending. With consumption such an important component of GDP, this inevitably drags down GDP growth.

At the height of the boom in 2007, household consumption accounted for 64 per cent of GDP. This has fallen to 62 per cent and the RBNZ is forecasting it to decline to 60 per cent by 2012.

Only time will tell if the bank has gone too far with its cuts to GDP growth. But the message is clear: we face a period of below-average growth thanks to the debt built up over the boom years.

The bank also warns that while house prices are expected to decline only modestly, there is a risk of a more noticeable decrease.

It notes that houses remain expensive relative to household incomes and that this, with increases in interest rates, is likely to limit demand and see real house prices (after accounting for inflation) decline over the next year or two.

Given the bank's mandate to deliver "price stability", inflation is a major topic of the MPS. The bank has also taken the hatchet to its inflation forecasts. In the June MPS it expected inflation to be 4.5 per cent this year.

It now expects inflation to be 3.8 per cent. The bank also cut its 2011 inflation forecast from 2.9 per cent to 2.4 per cent.

Weaker consumer demand, virtually non-existent lending growth, unemployment over 5 per cent, lower house prices and deleveraging will all contribute to muted inflation pressures.

The next inflation data release, for the September quarter, is due on October 18. The bank is expecting inflation to be 0.9 per cent over this quarter.

Even moderate inflation remains a significant risk to investors. A quarterly rate of 0.9 per cent means an investor would need to earn an annual return of about 5.1 per cent before tax just to break even.

The bank also states in the MPS that it will "look through" the one-off impact on inflation from the increase in GST, the emissions trading scheme and other tax changes. It estimates these factors will add 2.7 per cent to inflation, pushing the consumer price index to a peak of 4.8 per cent in June 2011.

Excluding the impact of these items, the underlying inflation rate is expected to be 2.1 per cent.

However, the bank does issue a warning in the MPS. If these one-off factors start to influence our behaviour then it will raise interest rates.

It will be watching price setting, wage negotiations and surveys of inflation expectations to see if there is any evidence that the hump in inflation is becoming ingrained. If so, expect rapid increases in the official cash rate.

Speaking of interest rates, the theme here is similar to that of economic growth and inflation - "lower for longer". The bank expects interest rates to rise a lot more slowly than it did at the time of the June MPS, which again reflects cuts to its GDP and inflation forecasts.

In the June MPS it was expecting interest rates to rise 3.1 per cent over the next two years, from the then current level of 3 per cent, by the end of 2012.

In the September MPS it expects rates to rise by only half as much. It forecasts 90-day bank bills to increase from 3.2 per cent to be 4.6 per cent in December 2012.

This reduction in the expected increase in interest rates is good news for those with floating mortgages. The bank expects to increase the OCR over coming years, but that the pace and extent of these increases will be lower than forecast in the June MPS.

Like most other forecasters, the RBNZ expects the NZ dollar to gradually depreciate. It forecasts it will hold its ground for the rest of the year with the trade-weighted index forecast to be 66.0 at the end of this year, down from 66.5. By the end of 2012, though, it is forecasting our currency to fall 6 per cent, implying a TWI of 62.5 at this time.

Softening commodity prices and higher interest rates overseas are two factors behind the bank's view of a gradual fall in our currency. While most of the focus in the MPS is given to the specific forecasts and the bank's commentary on the short-term situation, often its more general observations can be of more interest.

In the September MPS the bank poses a thought-provoking question of whether lower spending and greater emphasis on debt repayment is a typical cyclical response to a period of economic weakness, or whether it is the beginnings of a more deep-seated structural change in our attitude to debt.

We will possibly only get the answer to that in five or 10 years, when we have the next property boom.

Another interesting insight was over the impact of the deleveraging process on the global economy over the long term. The bank believes high debt levels across the Western world are likely to inhibit economic activity over the coming decade.

It argues that without meaningful reduction in government deficits, population ageing is likely to cause sovereign debt to increase markedly in many advanced economies. As well as pushing up interest rates, this would have a negative impact on global growth.

In our view, this comment highlights the serious issues facing the major developed economies: high debt levels, unsustainable government budget deficits and ageing populations. It suggests that investors need to position their portfolios towards assets offering sustainable income and inflation protection.

* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.