KEY POINTS:
We are staring down the barrel of another interest rate rise next week.
The Reserve Bank could raise the official cash rate from a Ukraine-matching 8 per cent to an Indonesian 8.25 per cent. The average among the major developed econ-omies is 4 per cent.
And yet the dollar is at an eye-watering US79c and another interest rate increase could send it higher still.
It is not as if the economy has been powering away like a runaway locomotive.
In the past two years it has expanded by an average 0.5 per cent a quarter, not much more than half its average rate over the past 10 years.
And the outlook is not all that much better.
Most economists' forecasts for annual growth over the year ahead are in the 2 to 3 per cent range - depending on their view of the relative strength of the headwinds from high interest rates and exchange rates and the tailwind from commodity prices.
So how come we have the kind of sticky, persistent inflation that would warrant the bitter monetary medicine governor Alan Bollard is dispensing?
Hot demand, hobbled supply
If demand for goods and services outstrips the economy's ability to supply them by too much for too long, inflation is the result.
In the inward-facing parts of the economy, where international trade is not a factor, inflation has been stuck around 4 per cent for nearly four years.
As Bollard scans the horizon on the demand side, he is looking at a dairy bonanza, a housing boom that just won't quit and the prospect of a stronger fiscal stimulus.
On the supply side the economy's "speed limit", its sustainable growth rate, is not what it was because of labour shortages and feeble productivity growth.
The Reserve Bank's estimate of the potential sustainable growth rate is 3 per cent.
But Bank of New Zealand economist Stephen Toplis thinks it is much lower, of the order of 2 to 2.5 per cent.
"The evidence of that is that over the last 12 months the economy has only grown around 2 per cent and the currency has risen dramatically, yet inflation continues to forge upwards."
Growth in the labour force is slowing and the population ageing and the gains from immigration are largely offset by emigration.
Statistics New Zealand's projection for labour force growth between 2006 and 2011 is 105,000, not much more than half the 192,000 increase in the previous five years.
That amounts to around 1.2 per cent a year and assumes medium rates of births, deaths and labour force participation and an average net inflow of migrants of 10,000 a year.
So far this year net immigration has been dwindling. For the first half the net inflow has been 2760. If that rate is sustained for the rest of the year, the gain will be less than half the average gain of more than 12,000 for the past 16 years.
Even after two years of below-par economic growth, the unemployment rate is only 3.8 per cent.
Businesses are reporting increased difficulty finding both the skilled and the unskilled labour they need, and the proportion citing labour as the factor most limiting their ability to increase output is at historically very high levels.
So a tight labour market suggests more wage inflation.
Higher levels of business investment and infrastructure spending have yet to show through in a surge in output per hour worked.
On the contrary, labour productivity growth has halved since the turn of the century, averaging 1.3 per cent a year between 2000 and 2006 compared with 2.7 per cent in the eight years before that.
If these trends in labour force growth and productivity continue, the economy will be capable of taking only shorter and shorter strides.
"Given a massive deterioration in productivity growth over the past five years, the supply side of the economy is clearly restrained," said ANZ National Bank chief economist Cameron Bagrie, "and this implies a greater adjustment from the demand side."
But indicators of demand suggest the Reserve Bank has its work cut out.
Superheated Housing
Westpac chief economist Brendan O'Donovan said Bollard's nightmare scenario would be to have to raise interest rates again and watch the dollar soar through US80c.
"Nonetheless he will do what it takes to bring medium-term inflation under control."
O'Donovan expects Bollard not only to lift the official cash rate on Thursday but again in September - unless the housing market hits the wall before then.
The latest figures from the Real Estate Institute looked weak, O'Donovan said, but it was all seasonal. Allowing for normal season patterns and the fact that the institute last month brought forward the cutoff date for agents to file their returns, the number of properties sold was down only slightly.
The median national house price was down $3000 but within the normal volatility from one month to another.
And there was no change in the average number of days it takes to sell a property, which remains brisk.
Mortgage rates have climbed since the June official cash rate rise.
"We believe rates at these levels will drive investors out of the housing market. But it's just not happening fast enough for the Reserve Bank," said O'Donovan.
The Reserve Bank expected house price inflation to fall to 8 per cent by the end of the year but the current rate of house sales suggested something close to 12 per cent.
"They have run out of options. The housing market is the only inflation driver they can tackle. They must ensure it is stopped in its tracks to offset pervasive inflation pressures. And they will."
White gold
But housing is not Bollard's only concern. The terms of trade, which is the ratio of export to import prices, is another.
Largely because world dairy prices have almost doubled in the past year, it is the strongest it has been since 1974 and 16 per cent above its long-run average level.
The prospect of a much higher payout from Fonterra next season was one of the main reasons Bollard cited for raising interest rates last month, and since then prices have climbed higher still.
Some of the factors underpinning that will prove temporary. Some consumer resistance to higher dairy prices can be expected, and production from drought-stricken Australia should eventually recover.
But other factors underpinning the improved terms of trade should prove more enduring.
As Asian incomes rise, so does demand for the foods of affluence, and at the same time the increasing integration of China and India into the global economy has brought down the prices of a lot of goods and services.
O'Donovan believes Fonterra's final payout will be well over $6kg of milk solids, rather than the $5.53 the company has foreshadowed.
"That represents over $3 billion in additional cash coming into the economy over the coming year. It doesn't stop at the farm gate."
But the flipside of higher commodity prices is a high dollar.
The impact varies from one export sector to another depending on what has been happening to their commodity prices and where their exports go and which exchange rates are relevant.
ANZ, which monitors such things, says that while conditions are stimulatory for the dairy sector, they are restrictive for meat, forestry, horticulture, seafood, manufacturing and services like tourism.
"In short, a boom for 20 per cent of our exports is not enough to offset the the other 80 per cent that are under the hammer," said Bagrie.
But BNZ chief economist Tony Alexander says we are not seeing "wholesale slaughter" in the export sector as a result of the high dollar, citing the continued tightness of the labour market as evidence.
"The is pain for some exporters but no evidence that at current levels the exchange rate is crippling the economy."
And while the kiwi has risen sharply against the US dollar and the yen, compared with the Australian dollar, euro and pound, it has hardly changed from levels 18 months ago.
An election year budget
Adding substantially to the demand side of the economy over the year ahead will be the Government's fiscal policy, essentially the difference between its revenue and its spending.
What matters for interest rates is how that gap changes from one year to another. The Treasury estimates it will change from a stimulus equivalent to 0.7 per cent of GDP in the June year which has just ended to a stimulus of 1.9 per cent in the year ahead.
And that does not take account of any further loosening of the public purse-strings, over and above that already in the Budget.
"The Government is under pressure in the polls and under pressure to reduce the size of the surplus and help out various groups in the economy," said Alexander. "Fiscal policy is going to be aggressively loosened in election year."
The high dollar and high interest rates aren't bad for everybody.
Among the winners are:
* People earning, rather than paying, interest - many of whom are retired.
* Consumers, who benefit from cheaper imported goods.
* Importers, to the extent that they pocket the currency gains rather than passing them on.
* Drivers, who would pay more at the pump if the dollar was weaker.
* Anyone who eats, for the same reason.
* People travelling overseas.
* Businesses buying capital equipment or raw materials or components offshore.
