The Reserve Bank has put a leash on New Zealand’s recovering economy, by raising interest rates to ensure patchy growth in sectors dominated by small and medium businesses does not become an inflation threat.

The Bank has increased the official cash rate by 25 basis points to 2.75 per cent, in line with unanimous predictions from forecasters at five major banks. Its Monetary Policy Committee says a small bump now will reduce the risk of a larger hike down the track.

“The Committee judged that increasing the OCR to 2.75 per cent is appropriate to sustainably return inflation to the 2 per cent target mid-point while avoiding unnecessary instability in output, employment, interest rates and the exchange rate.”

That is according to a statement from the Reserve Bank of New Zealand (RBNZ). While small business owners will welcome confirmation that the economy is growing, the prospect of higher interest rates comes as a blow after what has been described as a ‘rollercoaster year.’

“Business owners may see it as a case of one hand giving and the other taking away,” says Neil Webster, General Manager NZ for Employment Hero. “Just as business owners started to feel some relief, higher interest rates are back on the table to stop the recovery running too hot,” Webster says.

Why The Reserve Bank Was Adamant The OCR Must Rise

The RBNZ gave fair warning of the interest rate rise, declaring after its July meeting that subsequent hikes would likely be necessary to curb inflation, which reached 4.1 per cent in the June quarter following the Middle East conflict. But the Bank draws optimism from the fact that when expensive fuel is stripped from calculations, the Consumer Price Index (CPI) decreases to 2.9 per cent, which is within its 1-3 per cent target band.

“Inflation remains above target because of the oil shock but forward-looking indicators remain consistent with inflation returning to target,” says Governor Anna Breman.

The Bank expects inflation will stay high this year but should fall to within the target band by mid next year and hit the desired 2 per cent the year after. Instead of making bold moves or holds, it has committed to a ‘slow and steady’ approach to get there, declaring that even at 2.75 per cent, the OCR is historically low and it must be gradually raised towards a more neutral position.

Governor Breman acknowledges the impact of higher interest rates on small and medium businesses and households but says the Bank has a duty to ensure inflation does not become embedded in the economy. “Our assessment is we can bring inflation down while still supporting economic growth and employment,” Governor Breman says.

Indeed, by raising interest rates, the RBNZ is attempting to prevent the economy from growing too quickly, which could once again push up inflation. The Governor expects the recovery will strengthen and broaden. “There are signs of resilience in the New Zealand economy despite all the global uncertainties that we are facing,” she says.

Rate Hike Will Have An Uneven Impact On Businesses

While commentators were confident the RBNZ would increase interest rates, not all believed it should. Kiwibank economists say the economic recovery is too patchy to warrant a rate rise, with cost pressures ‘hurting regular Kiwi.’

“The price hikes in food, electricity, rates, insurance and many others, continue to frustrate businesses and restrain households,” they write. “Business and household incomes are not keeping up with the cost of these essentials. Businesses are struggling to pass on their higher costs to the already cash-strapped consumer. Margins are being squeezed.”

Webster says employees are battling real-time pay cuts, with Employment Hero’s Jobs Report for July finding wage growth has dipped into negative territory, contracting by 0.4 per cent year-on-year. “It means workers will continue to feel it in the back pocket, and for businesses whose margins haven’t recovered yet, another rate rise is one more cost to absorb before they’ve had the chance to catch their breath.”

But not all sectors are doing it tough. The lower New Zealand dollar means there is healthy demand for exports, particularly meat and dairy. “The data has been considerably stronger for the export sector than we expected,” says Governor Breman. Small and medium enterprises (SMEs) are well represented in agriculture, accounting for 98.5 per cent of businesses. “We know it will take some time before we see strong spillovers to the whole economy from that. But we do expect to see those spillovers.”

She notes that the current El Niño weather pattern increases the risk of drought and could pose a threat to a commodities-led recovery. But, in the interim: “It’s important to stress that bringing inflation back will support real incomes and household purchasing power. That will be good for demand and growth as well.”

Some Small Businesses May Avoid Immediate Impact

Higher interest rates inevitably result in higher borrowing costs but small business owners servicing loans may not face an immediate hike in repayments. With the writing on the wall after the RBNZ’s last meeting, markets had already factored in a higher OCR and increased their rates in recent months.

Global events will influence where the Bank goes from here. It concedes that a resumption of hostilities in the Middle East could once again force up fuel prices and the CPI. “We’re not on a pre-set course,” Governor Breman insisted. “We do think it’s likely there may be a future OCR increase but the timing is highly uncertain.”

Westpac Chief Economist Kelly Eckhold expects the cash rate will end the year at around 3 per cent but warns the rebound remains fragile and significant risks linger. “Care should be taken to not take the recovery for granted, especially while the improvement in the labour market remains embryonic,” he says.

With the unemployment rate sitting at a decade-high 5.6 per cent, Governor Breman says jobs are a factor in the Bank’s decisions. “This is still a really tough labour market for many households, particularly young households,” she says. “The labor market matters but it’s complex.”

Webster says despite general softness, green shoots are emerging as some small and medium businesses find the confidence to increase headcount. “According to our data, SMEs saw an expansion of 1.7 per cent month-on-month in July, making it the strongest monthly gain in nine months,” he says.

While the November election may add another uncertain element into the mix, RBNZ Committee member Karen Silk says business owners appear to be taking short-term challenges in their stride. “In the business visits we’re doing, they’re indicating they’re just getting on with it,” she says. “So, we’re confident that New Zealanders are still focused on what we are going to do over the longer term.”

The RBNZ’s next OCR decision is due on 28 October.