KEY POINTS:
The prospect that inflation will continue to rise has prompted Westpac economists to predict the central bank will lift the official cash rate twice this year to an eye-watering 8.75 per cent.
Consumer Price Index data tomorrow is expected to reveal that inflation has punched through the 3 per cent upper limit of the Reserve Bank's target band.
Westpac and ASB economists are expecting the CPI to have increased by 1.1 per cent over the December quarter, taking the annual increase to 3.1 per cent from 1.8 per cent during the October quarter.
Westpac says the drivers of rising inflation over the period are higher petrol and air travel prices, rising rents and local body rates, and hefty food price increases.
While the trading banks' December quarter forecasts are consistent with those from the Reserve Bank "it is the outlook that has us most worried", said Westpac chief economist Brendan O'Donovan. "We think annual inflation is headed for 4 per cent through 2008."
The Reserve Bank is now forecasting inflation will hit 3.5 per cent in the third quarter of this year and average just under 3 per cent over the next three years.
Westpac has viewed further rate hikes as a strong possibility since late last year, but in forex commentary yesterday the bank said it expected two hikes this year "unless global credit markets deteriorate further".
"New Zealand's got an inflation problem," said O'Donovan. "The Reserve Bank's already forecasting inflation to be averaging 2.8 per cent over the next three years and that's perilously close to the top of their target band."
However, he believed the Reserve Bank had "either not included, or undercooked the number of inflation elements" in its forecasts. They included capacity constraints, which were highlighted in yesterday's quarterly survey of business opinion, further food, energy and transport price rises and "dairy farmers showing a propensity to spend rather than pay down debt".
"To cap it all off, there's got to be upside risk to the RBNZ's working assumption of $1.5 billion in tax cuts."
Further out, both O'Donovan and ASB chief economist Nick Tuffley believed the Reserve Bank's forecasts underestimated the inflationary impact of the Emissions Trading Scheme which kicks off next year.
"The problem is when the RBNZ fully incorporates all these inflation shocks, then their inflation forecast would average over 3.5 per cent over the next three years and if that's the case, you can't sit idly by, they have no choice," said O'Donovan.
"At the moment credit market concerns are doing the RBNZ's tightening for it", but he believed the central bank would be forced to act and would raise the OCR again in March.
However, Tuffley believed the tough credit market conditions, which have increased interest rates recently independent of the Reserve Bank, would provide enough breathing space to prevent further OCR increases.
Meanwhile, commenting on yesterday's quarterly survey of business opinion, Bank of New Zealand senior market economist Craig Ebert altered his timetable for the OCR cut he still expects this year, moving it from the third quarter to the fourth.
"Today's quarterly survey of business opinion proved more robust, and thus inflationary, than many would have been expecting. The Reserve Bank won't like this survey one little bit. We are formally pushing out our expected first easing to December, with the very real possibility that it is delayed even further.
"A further tightening should not be ruled out. We judge the probability now around 25 per cent."
ANZ economist Cameron Bagrie said his bank's forecasts for inflation were broadly in line with the Reserve Bank's.
While a breach of the 1 to 3 per cent target band appeared inevitable, he saw little chance of an OCR increase this year, mainly due to the uncertain global environment. On the other hand, he saw little chance of a cut, due to persistent inflation.
INFLATION WOES
* Data tomorrow is expected to show annual inflation has breached the upper limit of the Reserve Bank's 1 to 3 per cent target band.
* Westpac economists say the Reserve Bank has underestimated inflationary factors and will be forced to raise interest rates twice this year.
* It is predicting the first increase in March.
