Budget tax overhaul set to fuel inflation spike

A trolley load of shopping will cost more soon, as Treasury increases its inflation predictions. Photo / Martin Sykes

Inflation is set to spike higher than economists had predicted as a result of the increase in goods and services tax and other levies and imposts, adding to expectations the central bank will begin hiking interest rates at its next meeting on June 10.

The Treasury is forecasting the consumer price index will jumped to 5.9 per cent in the first quarter of 2011, more than twice its estimate of six months ago. The department raised its projection for the track of CPI for the next four years.

Consumers are expected to lift spending, particularly on durable goods, ahead of the GST increase on Oct. 1. Real output is expected to grow about 3 per cent a year starting with a 3.2 per cent gain in the 12 months through March 2011, having contracted 0.3 per cent in the year just past. Reserve Bank Governor Alan Bollard had urged the government to be wary of creating too much fiscal stimulus, creating a bigger monetary policy job for the central bank.

"The near-term impact of the Budget is more stimulatory than we had expected and will add to demand in aggregate," said Darren Gibbs, chief economist at Deutsche Bank. "All other things equal, this implies less scope for the Reserve Bank to maintain very easy monetary policy settings."

Gibbs said markets now see a greater likelihood that Bollard will raise the official cash rate from a record low 2.5 per cent on June 10 and the central bank may be contemplating the scope for English's

2011 to be more stimulatory than he indicated at the release yesterday, given it is election year.

The Treasury lifted its forecast for GDP growth for the year ending March 31, 2011, from the 2.4 per cent pace it projected in December.

Taken over the four-year forecasting horizon, core Crown tax revenue is now expected to be $65.4 billion, or $1.6 billion more than was flagged six months ago.

Bollard's latest wording for a resumption in OCR hikes was "in coming months" and at his April 29 review he said the wider gap between the OCR and lending rates mean the increases are likely to be "more effective." That should "reduce the extent to which the OCR will need to be increased relative to previous cycles," he said.

In fact, apart from the one-off spike in inflation in the March quarter, the Treasury is projecting a more benign track for CPI over the next four years, at an annual pace of 2.4 per cent than Bollard prediction in the March policy statement of 2012 inflation of 2.8 per cent and 2.7 per cent in 2013.

That provides a level of comfort for the Reserve Bank in targeting inflation of between 1 per cent and 3 per cent on average.

"The Reserve Bank has long been calling for a period of fiscal consolidation to assist in the job it needs to do," said Philip Borkin, economist at Goldman Sachs JBWere. "It does appear the Reserve Bank is getting its wish, although you could argue the larger fiscal impulse in FY11 means that it is delayed longer than initially expected."

The timing and pace of rate increases will also be determined by the global economic health, with Europe's debt crisis still undermining financial markets and speculation China will begin to cool its economy.

"Heightened concerns, if it begins to see an intensification of bank funding costs, could see the Reserve Bank decide to sit on its hands a while longer," Borkin said. "But beyond this, our view remains that the tightening cycle will be relatively gradual."

Finance Minister Bill English was able to unveil a healthier set of projections because the economic recovery is proving sturdier than was expected in the Treasury's December fiscal update.

New Zealand's output suffered the smallest dent of any OECD country after Australia and Poland, helped by demand from a resilient economy across the Tasman and from China, the world's fastest-growing major economy.