Bollard warns of inflation till mid-2007

The Reserve Bank expects inflation to be stronger for longer, fuelled by rising oil prices and a sinking dollar, but warns it will hold the line against that spilling over into "extravagant" pay rises or price hikes.

It sees inflation hitting 3.9 per cent in the present quarter and not falling back below 3 per cent until the second half of next year.

As expected, Governor Alan Bollard yesterday left the official cash rate on hold at 7.25 per cent.

But the financial markets read the accompanying Monetary Policy Statement as hawkish and promptly pushed the dollar and wholesale interest rates higher. By the end of the day, however, the kiwi had come back to US62.80c, only a little above Wednesday's close of US62.70c.

The futures market now sees only a 50:50 chance the bank will start to cut interest rates in April next year and is only fully pricing in a cut by June, while the swaps market pushed the two-year rate - a key driver of fixed mortgage rates - up 10 points to 7.2 per cent.

ANZ National Bank chief economist Cameron Bagrie said the market reaction seemed to overlook that the central bank had acknowledged economic growth had turned out weaker than it expected three months ago and that that would reduce medium-term inflation pressures - which is where the bank's focus should be.

The bank continues to forecast a soft landing, with growth bottoming out at 1.6 per cent over the year ahead.

Bollard rejected the suggestion that he should be cutting interest rates now in light of the weak growth outlook and the time it takes for rate cuts to do their work.

"The fact that growth comes off in the short term isn't for us a trigger to immediately change policy," he said.

"We will keep looking at the future track for inflation in the medium term."

Bollard stressed that the short-term jump in projected inflation reflected a 20 per cent rise in oil prices in the past three months and a steeper-than-expected fall in the exchange rate.

"Given the unavoidable nature of these price shocks it would be inappropriate for monetary policy to try to counteract their short-term inflation effects.

"However, it is essential that monetary policy hold the line against any second-round effect that could be felt in wages, prices and inflation expectations."

Bank of New Zealand head of research Stephen Toplis said Bollard was "running scared" about inflation expectations becoming entrenched at a higher level.

"Annual inflation has already been outside the target range [1 to 3 per cent] for three quarters and the bank is now forecasting it to remain so for another six. There must be a very real risk that wage and price-setters come to accept 3 per cent inflation as their benchmark for decision-making."

The bank is not counting on any let-up in wage inflation in the next year.

And it noted that while longer-term inflation expectations remain below 3 per cent, they have been edging up.

Toplis said that the bank's inflation track was based on some "potentially heroic" assumptions.

One was that the impact of the lower dollar on the price of imported goods would only be passed on to consumers to a limited extent.

Another was that house prices would fall around 5 per cent, shutting down the additional consumer spending which had been fuelled by homeowners borrowing against the rising equity in their properties.

And the bank was assuming world oil prices would fall by about a third over the next three years.

Appearing before Parliament's finance and expenditure committee yesterday, Bollard was asked why the bank assumed the oil price would fall.

"Because it is so high now. What goes up comes down," he said.

The question was how long it would take the oil industry to bring additional supplies and refinery capacity on stream in response to the very strong price signal it had received.

Foretelling the future

* Growth slows to 1.6 per cent over the coming year before an export-led rebound.

* Inflation hits 3.9 per cent and does not fall below 3 per cent until late 2007.

* Dollar drops sharply over the rest of this year.

* Unemployment creeps up but stays below 5 per cent.

* Current account deficit hits nearly 10 per cent of GDP before it starts to shrink again.