Bollard stays hawkish on interest rates

Reserve Bank Governor Alan Bollard left the official cash rate unchanged at 6.5 per cent yesterday but repeated last month's warning that he sees little scope for lower interest rates "in the foreseeable future".

As in December, Bollard said last year's interest rate rises and the high dollar would slow the economy over the year ahead sufficiently to keep inflation within the target band of 1 to 3 per cent.

However, inflation was 2.7 per cent in calendar 2004 and the bank expects it to remain near the top of the target band over the medium term, leaving little headroom if inflation pressures prove stronger than it expects.

In that case, higher interest rates could not be ruled out, Bollard warned.

"There is clearly a risk that the current momentum in household demand will hold up longer than expected."

Wage rises also presented an inflation risk, given the persistent tightness of the labour market.

But on the other hand, Bollard said, there was a risk of a stronger dollar, weaker exports and less inflation pressure.

Bank of New Zealand economist Stephen Toplis said the strength of the dollar was about the only thing holding inflation in check.

"If it shows any sign of wilting whatsoever, the pressure will really go on the bank."

Before yesterday's statement the financial markets had priced in some chance of an interest rate hike in the next few months, in light of data showing continued strength in the economy, robust retail sales in November, a rebound in housing market turnover, higher than expected inflation in the December quarter and ever more acute skilled labour shortages reported in the quarterly survey of business opinion.

But Bollard's statement was less hawkish than the markets expected. The dollar weakened and short-term wholesale interest rates eased.

Toplis said employment figures due on February 11 could be critical in determining the bank's next move.

"The bank is picking the unemployment rate to stabilise at 3.8 per cent but we think there is a very real chance of a further [fall to] 3.5 per cent. If we are right that could be the straw that breaks the camel's back."

National Bank chief economist John McDermott expects Bollard to keep rates on hold until the end of the year, while others expect him to start cutting interest rates in the second half of the year.