Video: Business editor Liam Dann on today's announcementKEY POINTS:
The Reserve Bank today said it expects the annual inflation rate to leap to 4.7 per cent this year, the highest level in 18 years, but bank governor Alan Bollard still signalled a cut in interest rates.
Dr Bollard, as expected, left the official cash rate unchanged on 8.25 per cent.
He painted a bleak picture of the economy and because of that said the bank would cut the Official Cash Rate (OCR) later this year despite the rampant inflation.
He said the forecast cut "is sooner than previously envisaged" and the bank noted financial markets are forecasting the first rate cut in October.
The economy faced "the uncomfortable combination of rising inflation and weak economic growth" - often referred to by economists as stagflation.
"These costs shocks and their adverse consequences are very challenging for the Reserve Bank and for many central banks around the world that are currently grappling with the same low growth/rising inflation scenario," Dr Bollard said.
MAIN POINTS FROM TODAY'S ANNOUNCEMENT:
* annual inflation rate expected to leap to 4.7 per cent this year
* rate cut may come from central bank in October
* lack of growth in economy is Bollard's principal concern
* RBNZ forecasts house prices forecast to drop 13 per cent
* The bank projects the NZ dollar to fall faster than assumed
* Bollard calls for moderation in wage expectations and demands
* Most economists are applauding the bank's long-term vision
The bank assumes the NZ dollar trade-weighted index will fall 14 per cent over three years, but it may occur much quicker and much more deeply than that.
The bank projects the currency to fall faster than assumed in its March forecasts and it said that there was a significant risk it could fall even more rapidly.
The bank projects wholesale interest rates - 90 day bank bills - to fall from around 8.8 per cent to 8.1 per cent in the first half of next year, and to 6.7 per cent by the second half of 2010.
"One of the reasons we are not projecting even more easing in monetary conditions is because the experience of the 1970s warns us of the danger associated with easing monetary conditions too rapidly in the face of sharp oil price increases," the bank said.
The soaring inflation rate, already outside the bank's 1-3 per cent target range, is blamed largely on oil and food prices while underlying inflation pressures from price and wage rises were persistent.
Dr Bollard expects economic growth to come to a virtual standstill this year due to household spending hitting the wall and only modestly recover thereafter.
GDP in the year to March 2009 is seen at just 0.9 per cent against 1.9 per cent growth projected by the bank in March. In 2010 growth is seen at just 1.4 per cent.
Stimulus provided by the Government's tax cuts and new spending announced in the budget would provide some offset to the lower growth but would add to medium-term inflation pressure.
The bank's grim projections include an assumption that house prices will fall from their peak last year by 13 per cent. If inflation is taken into account, the bank projects house prices to fall 22 per cent. After the first oil shock in the 1970s real house prices fell 38 per cent.
Since the March forecasts when inflation was expected to peak around 3.5 per cent, oil prices had risen dramatically.
Because of the economic slowdown, the inflation rate is expected to come off but still be above the bank's target all through 2010. Household spending is projected to contract over the next two years despite the tax cuts.
The additional stimulus provided by the budget was "relatively small" in the context of other factors in the economy.
Dr Bollard said the bank should be able to "look through" the first round effects of the breach of inflation target but he issued a warning.
"If firms and workers start negotiating prices and wages on the expectation that inflation at, or above, 3 per cent is the norm, then the bank would have to respond with higher interest rates than assumed here."
The bank assumes the oil price shock is temporary and prices had peaked although it notes oil futures traders do not assume any such fall. But then the Government's Trading Emissions Scheme will come in, adding to inflation pressures.
Dr Bollard said that in contrast to past economic contractions "we are projecting a relatively long period of low growth".
The weaker economy will see the unemployment rate rise sharply - from 3.6 per cent to 6 per cent in 2011.
ANZ National Bank chief economist Cameron Bagrie said Dr Bollard's flexible view on the future is encouraging.
"It's reality bites. That was a clear acknowledgement that the economy has slipped into a big hole," Mr Bagrie said.
"In the overall scheme of things, you respond to economic development and the economy is clearly weak. They've got a negative quarter 1 for GDP and Dr Bollard can't discount a technical recession," Mr Bagrie said.
He said the recession has not reared its head in the data as yet but the second quarter is not likely to be any better.
"The economy is flat at best and we're going to do very well to get any growth at all," Mr Bagrie said.
But Westpac economist Sharon Zollner said the Reserve Bank looked overly pessimistic on growth.
"They're picking a slowdown that's much longer than New Zealand typically sees," she said.
"In our experience it's not how the New Zealand economy works, and based on the fact some of the slowdown is drought-related we think there are factors that are going to cause growth to bounce back, so we would definitely see upside risks to their assumptions."
First NZ Capital chief economist Jason Wong said "it was a pretty good statement in a very challenging environment".
"It's softer than the market expected, but it's hard to disagree with what they're saying. We're seeing an oil shock, which while creating inflation pressure also creates a much weaker economic environment further down the track, which is what the (Reserve) Bank's reacting to."
Independent economist Donal Curtin told NZPA the signal the bank is about to cut interest rates meant the New Zealand dollar was likely to fall heavily.
"It will fall like a stone. It will be one way traffic," he predicted.
The New Zealand dollar fell sharply on the news.
In late afternoon trading in New York, the New Zealand dollar did indeed plunge, falling almost 1 per cent lower on the day at $0.7725, down from $0.7795 prior to the central bank's decision.
- NZPA, NZHERALD STAFF
What is monetary policy? - An explanatory document by the Reserve Bank of New Zealand.
