Bollard signals interest rates may move up soon

Alan Bollard

Reserve Bank Governor Alan Bollard today warned there may be more rate hikes this business cycle, as he left the Official Cash Rate (OCR) unchanged at his quarterly review of monetary conditions.

The message was effectively a back-track on last quarter's signal that there are unlikely to be any changes in the foreseeable future.

He has left the OCR unchanged at 7.25 per cent all this year despite annual inflation being outside the bank's 1-3 per cent target band for four quarters.

In a "hawkish" statement, Dr Bollard said the bank saw more inflation pressure than in the June quarter review and the inflation rate was not expected to fall below 3 per cent until late next year.

"In these circumstances, we are less confident that no further policy tightening will be required in this cycle," he said, adding that there was no prospect of an OCR cut for some considerable time.

The bank's assumption for the 90-day bank bill rate, from which banks fund mortgages, is to have a small rise next year and no drop until the first half of 2008.

Dr Bollard said the economy continued to show resilience despite clear signs of an easing in activity. There had been a rebalancing of demand from domestic to the external sector since late last year.

"However, economic activity appears to have been stronger than expected through the first half of 2006, with the expansion of employment particularly surprising," he said.

Net exports and government spending had contributed to the buoyancy but household consumption had been more moderate than projected.

Although the housing market had slowed, it "continues to exhibit momentum".

Dr Bollard said he expected the effects of higher oil prices and last year's interest rate rises to further dampen demand.

"But even allowing for these effects, we see more inflation pressure than in earlier reviews."

He noted that oil price rises and the fall of the New Zealand dollar had helped push annual inflation to 4 per cent in the June quarter.

While second-round flow-on effects had so far been limited, inflation expectations had continued to drift upwards, influenced by the rising headline numbers. The risk of second-round inflation (passing on costs) had increased because of the persistence of demand and labour market pressures, Dr Bollard said.

"Given the continued strength of medium-term inflation pressures, the outlook for monetary policy has become more finely balanced."

This is Reserve Bank-speak for moving monetary policy away from an easing bias towards a tightening one, where the next more in the cash rate could be up.

Dr Bollard said there was little leeway to withstand further surprises to medium-term inflation pressures and the balance of risks was on the upside.

Higher oil prices had contributed a quarter of the 4.0 per cent inflation rate, and Dr Bollard blamed these for "almost all the upside surprise to our headline inflation number".

In the June quarter, the bank had projected crude oil prices to fall to US$45 by some time in 2008 but this quarter it made a less heroic projection, of around US$53.

The bank projects slightly higher near-term economic growth than in the June quarter but the rebound in 2008 and 2009 will be milder. Growth in the year to March 2007 is projected at 1.8 per cent (1.6 per cent in June) and in 2008 is seen at 2.4 per cent (previously 2.7 per cent).

Although Dr Bollard forecasts a "soft landing" for the economy, as he has for some time, the growth rate is projected to be "sub-potential" for a prolonged period.

The New Zealand dollar rocketed up immediately after the Reserve Bank's 9am statement, and within 21 minutes was up three-quarters of a cent against the US currency to US65.36c.

UBS economist Robin Clements said, despite Dr Bollard's comments, he did not think there would be any rate hikes.

"They see growth being a bit stronger than expected, more resilient, inflation pressures a bit higher than their previous reviews and as a result the key words are 'less confident that no further policy tightening will be required'."

ANZ-National Bank chief economist Cameron Bagrie said he was sticking to the view that the Reserve Bank would cut rates in mid-2007, as opposed to raising them.

"Dr Bollard's saying enough is enough, he's lost patience, he's seen the slowdown in growth but it's just not quick enough to satisfy the risk posed by inflation," he said.

"I think he's setting the economy up for a hard landing or an outright recession."

First NZ Capital senior economist Jason Wong said he was a little surprised at the firmness of the statement in light of the strength of the currency over the past couple of months and the big fall in oil prices.

"The bank is putting a lot of emphasis on the domestic economy, employment, capacity constraints, etc."

Deutsche Bank chief economist Darren Gibbs said the statement was clearly more hawkish than the market expected.

"The RBNZ sounds almost like its at the end of its tether on inflation risks," he said.

"It means there's a real risk now that rates will have to go higher. October is probably too early, but if we don't see a definite slowdown by December, there has to be a significant chance of a hike."

- NZPA