Close call on rates as dollar flies

By BRIAN FALLOW economics editor


Markets economists expect Reserve Bank Governor Alan Bollard to leave interest rates unchanged at Thursday's review, but they stress it is a close call.

On balance, uncertainty about the outlook for the exchange rate is thought to be great enough to commend to him the maxim, "when in doubt, do nowt".

Financial markets ended last year highly confident Bollard would hike rates at the first opportunity, but that confidence waned as the exchange rate soared in the new year - largely the flipside of weakness in the United States dollar.

Some of those currency gains have been recently given up as European ministers and central bankers publicly fretted about the speed of the US dollar's decline and the uneven distribution of the corresponding appreciation of other currencies.

Uncertainty about the possibility of concerted action to slow down the US dollar's decline is expected to overhang global foreign exchange markets at least until after the G7 meeting of leading industrial powers next week.

At the time of the bank's last monetary policy statement in December, Bollard foreshadowed the likely need for interest rate increases of three-quarters of a percentage point, reversing the precautionary rate cuts he made last year when the outlook was clouded by Iraq, Sars and the prospect of electricity shortages.

But the December forecasts assumed an exchange rate of 65 on the trade-weighted index on average over the first half of this year.

Even after its retreat last week the TWI is already 2 per cent ahead of that - which in the days of the monetary conditions index was regarded as having the same growth-retarding effect as a one percentage point increase in interest rates.

To be weighed against that are fresh indications of inflation pressures mounting in the domestic economy.

The Institute of Economic Research's quarterly survey of business opinion recorded further increases in the shortage of skilled and even unskilled labour, a harbinger of wage inflation 18 months from now.

ANZ Bank's job advertisements series, which showed unseasonably strong levels of advertising last month, is further evidence of the tightness of the labour market, where the unemployment rate is at a 16-year low.

The Reserve Bank's calculation of how stretched the economy's resources are will also be affected by a higher starting point, after September quarter economic growth came in at a robust 1.5 per cent where the bank had expected only 1 per cent.

Consumer sentiment is the perkiest it has been for eight years, underpinned by strong employment and wage growth and, for home owners at least, the feel-good effects of 20 per cent house price inflation.

Meanwhile consumer price inflation in the December quarter at 0.7 per cent was well above the 0.4 per cent the bank had forecast.

Inflation in the interest rate-sensitive, non-tradeables sector was 1.5 per cent, making 4.6 per cent for the year. But Deutsche Bank's Ulf Schoefisch says that if the housing-related elements are removed, annual non-tradeables inflation was a relatively well behaved 2.8 per cent, while on the tradeables side (influenced by the exchange rate) prices fell, by an average 1.3 per cent.

Fewer prices rose in the December quarter than in the September quarter.

In short, there is little sign yet of an inflationary bushfire spreading from the incendiary housing sector into prices more generally, which is what the Reserve Bank has to worry about.

Nevertheless most market economists expect the bank to start raising rates in March - unless the dollar resumes its rapid climb.

"At this stage we are sticking with two 25 basis point rises in the official cash rate in March and June, which is broadly in line with current market pricing," said National Bank economist Cameron Bagrie.

"Critically this assumes the New Zealand dollar does not continue its turbocharged run, gives up some of its recent gains in the near term and businesses do not wrap themselves in gloom."

Wespac chief economist Brendan O'Donovan said that if the dollar held up, any tightening in interest rates was likely to be mild - no more than 50 basis points over March and April.

"And New Zealand dollar soaring above 70USc could see no need for a higher official cash rate this year."

Bank of New Zealand economist Stephen Toplis said that if the Reserve Bank believed the currency's recent highs would soon be repeated it would have little excuse to raise interest rates.

"Conversely if the bank sees the recent spike as no more than a blip the buoyancy of domestic data would force it to take aggressive action."