Brian Fallow: Reaping the Brash dividend

One good thing about a dollar at post-float highs - it lessens the chances that Alan Bollard will raise interest rates on March 10. Not everyone thinks that is a good thing, however.

The Bank of New Zealand's economists believe the governor is looking at a menacing inflation outlook through rose-tinted glasses and has given the economy the benefit of too much doubt.

They believe the currency will before long cease to have a dampening effect on prices, that demand will continue to outstrip the economy's capacity to supply and that inflation expectations are creeping relentlessly higher.

If they are right, that amounts to a pretty compelling case to hike rates.

Bollard is in the poignant position that having raised the official cash rate 150 basis points last year the impact on the household sector so far has been somewhere between negligible and nil, but by international standards New Zealand interest rates are attractive.

That has encouraged foreign borrowers to issue eurobonds and uridashis - debt denominated in New Zealand dollars and paying New Zealand interest rates - which has helped push the kiwi dollar to the highest level against the greenback since it floated nearly 20 years ago.

To raise interest rates in this environment risks pushing the exchange rate to icy heights where the air is too thin for some exporters to survive.

BNZ economists are forecasting inflation to be above 3 per cent, the top of the Reserve Bank's target band, all through 2006 and the first half of 2007.

They have the inflation rate peaking at 3.4 per cent in the middle of next year, but say it is not hard to come up with a scenario in which it pushed through 4 per cent.

Over 2004, the consumers' price index rose 2.7 per cent. That masks a sharp divergence between 4.3 per cent inflation in the domestic or non-tradeables components and 0.7 per cent in the tradeables sectors which are influenced by the exchange rate and disciplined by international prices.

Non-tradeables inflation, which has been running above 4 per cent for 18 months, reflects how much pressure present levels of production are placing on the economy's resources, notably the labour supply and plant and machinery.

That pressure is intense.

The labour market is tight enough to pull the unemployment rate down to a world-beating 3.6 per cent and push the participation rate to new highs.

And the principal measure of spare physical capacity, the Institute of Economic Research's capacity utilisation index, is the highest it has been since the measure began in 1961.

"History would suggest non-tradeables inflation could well accelerate further from here. At least it seems likely that domestically generated inflation will hold up at current levels over the next 12 months or so," the BNZ says.

"From there, a substantial slowdown in growth over the next year or so should relieve capacity pressures to a certain extent."

It takes a long time for a tight jobs market to show up as higher wages.

BNZ economist Craig Ebert said: "Because of the lags, you could argue the wage inflation we are seeing now reflects an unemployment rate of maybe slightly below 5 per cent. It hasn't begun to reflect anything below 4 per cent yet."

On the tradeables inflation side, the BNZ expects the factors which have been keeping the exchange rate up and the prices of imported goods down to fade.

As the US Federal Reserve continues to tighten interest rates, the interest rate differential will erode. With global growth slowing commodity prices, another key influence on the exchange rates, should drift lower.

Finally, the BNZ argues that even though Bollard raised the official cash rate 150 basis points last year, the inflation rate rose 110 basis points over the same period, so that the increase in real encases rates, which is what matters, was much more modest. "At around 3.75 per cent real rates are barely at the level the Reserve Bank itself says it regards as neutral [neither stimulating nor restraining the economy]. Yet what's needed is a real cold shower for the household sector," Ebert said.

The BNZ's is a minority view, however, from the hawkish end of the spectrum.

Deustche Bank chief economist Ulf Schoefisch, by contrast, said if Bollard were to resume the interest rate-tightening cycle it would be a high-risk strategy, significantly increasing the chances of a hard landing.

He says economic growth is already slowing in response to the pressures in the system.

Growth slowed to annualised pace of about 3 per cent in the second half of last year, from 5.8 per cent in the first half.

He expects the pace to slow further to about a 2 per cent rate in the first half of this year under the combined influence of weaker population growth, higher interest rates starting to bite, the exchange rate hurting exporters' competitiveness and the feel-good factor from higher house prices waning.

While the inflation rate is uncomfortably close to the top of the target band the inflation pressure has not been broad-based.

The housing sector, global oil prices and structural adjustments in the electricity sector account for about two-thirds of it.

Retailers, meanwhile, continue to complain about low pricing power and, in the last quarterly survey of business opinion, the proportion of merchants expecting to raise their prices fell. Schoefisch sees the inflation cycle as close to its peak, with a softer residential building sector easing non-tradeables inflation, while the dollar remains high over the coming year, keeping tradeables inflation in check.

Westpac chief economist Brendan O'Donovan believes a cooling housing market will take the heat out of inflation. Housing market turnover in January suggested that the rebound in November and December was a temporary response to the price war among lenders.

While it might be true that interest rates are not at restrictive levels, overall monetary conditions, including the exchange rate, are extremely tight.

He said, ideally, Bollard would prefer a different mix, with higher interest rates and a lower exchange rate, but he could not control the mix.

ANZ National chief economist John McDermott says on balance Bollard can afford to keep rates on hold.

Households are carrying more debt in relation to their incomes than they used to, which should make them more sensitive to interest rates.

In the short term, the effect of last year's official cash rate hikes has been negated by borrowers' preference for fixed-rate loans and the price war among the banks.

But as those rates roll off (the average term of a fixed rate loan is a year and five months), the effect of those rate hikes on households' spending power will be felt.

A key judgment Bollard has to make is on the degree of risk of there being some kind of step-up in inflation expectations.

Like Don Brash before him, he has a statutory duty to deliver stability in the general level of prices.

But how price stability is defined, in the governor's employment contract, has been relaxed somewhat in the belief that people are confident low inflation is now a permanent feature of the economy.

His mandate is to keep inflation between 1 per cent and 3 per cent on average over the medium term.

It is not a hard-edged target. He is allowed to stray over the edge provided measures are in place to bring it back down again.

Getting rid of the cost-plus mentality and creating an environment in which every commercial decision no longer had to include some mental adjustment for inflation was a long and arduous task. Surely, it is a lesson that does not have to be learned twice.

You might call it the Brash dividend. This is when Bollard gets to collect it.