Bollard hawkish over rate rises

Alan Bollard

The economy is going strongly and inflation pressures persist.

But the Reserve Bank believes there is enough of a braking effect still to come from its six interest rate rises this year and a high dollar for it to keep the official cash rate on hold at 6.5 per cent.

That was the message from Governor Alan Bollard yesterday and it was essentially what he said six weeks ago.

Back then the message came as something of a surprise and the markets heard, or thought they heard, the cooing of a dove in the background.

This time there is no doubt it is the menacing shriek of a hawk. Three times the December monetary policy statement warns that higher interest rates cannot be ruled out.

Even with the economy forecast to slow from a cracking 4.75 per cent pace in the year to next March to a plodding 2 per cent for the next two years, inflation will still nudge the top of the bank's 1 per cent to 3 per cent target range.

That left little headroom to absorb stronger-than-expected inflation pressures, Bollard said. If such pressures emerged, another policy tightening could not be ruled out.

"Further, the current outlook offers little scope for an easing in policy in the foreseeable future."

This is a clear message to financial markets that they have, in the bank's view, got ahead of themselves in pricing in a reasonable chance of lower interest rates by the middle of next year.

"The markets have been assuming the downside risks are more significant than the upside ones. We don't think so. We think they are balanced," Bollard said.

Following yesterday's statement, the futures market still expects the next move in interest rates to be down, but later next year.

"It is still pricing in a very real chance of an easing in the third quarter," said BNZ economist Stephen Toplis.

Market economists regard the bank's latest economic forecasts as credible and mainstream, but note that it has revised up its view of the economy's potential for sustainable growth rate to around 3.75 per cent.

Even if it is right about this - and it is not something that can be directly measured - growth for the past three years has been at even higher, unsustainable rates and has to come down.

But it is still a more liberal speed limit than the sub-3 per cent rate the bank used to envisage.

"That's quite a big increase," Bollard said, appearing before MPs on the finance select committee.

The number was not hard and fast. But it was a critical judgment the bank had to make, he said.

If it underestimated the potential growth rate it would run monetary policy unnecessarily tight.

"But we can't afford to be too optimistically benign, either. We have got to see some of this happen."

In some ways, he said, New Zealand was looking like the 1960s: more people, more cows and better prices for dairy products.

"But we have seen enough cycles to know it is not easy being a commodity exporter. You do have good times but you can't always count on them."

The bank's forecasts assume the exchange rate will remain around present levels on a trade-weighted basis for about a year before heading lower under the influence of softer commodity prices, a narrower gap between New Zealand and overseas interest rates and a widening current account deficit.

"We can't forecast the track of the US dollar. Nor, we believe, can anybody," Bollard said.

"But we observe that the overwhelming comment at the moment is there is further downside risk to it and this is in response to the structural fiscal and current account balances in the US. That has clearly got the potential to impact on us."

But in the meantime exporters were coping.