Govt spending still a risk to monetary policy

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Government spending is still on Reserve Bank Governor Alan Bollard's mind, even after Finance Minister Bill English stripped all new expenditure out of his programme in this year's budget.

The impact of the Canterbury earthquakes and Europe's ongoing sovereign debt crisis are still threatening the government's fiscal policy, and that may force Bollard's hand when setting monetary policy, he and his deputy Grant Spencer said in the foreword to the bank's Statement of Intent.

New Zealand's economic growth was underpinned by strength in East Asia and Australia with record prices for locally produced raw materials, but may vacillate amid increasing volatility.

"With the earthquake and fragile international sovereign debt markets, the government's fiscal burden is significantly tougher and that may have implications for monetary policy," they said.

"High commodity prices have become an important engine of growth, but we expect price volatility will pose challenges for monetary policy."

In 2009, Bollard gave the government a serve over its spending programme, singling out tax reform as a way to boost the effectiveness of monetary policy. English has clamped down on spending since the National-led administration took power at the end of 2008, and he delivered a zero-budget this year.

The bank's top priority this year is to assess the impact of the Canterbury earthquakes, which have killed more than 180 people and caused as much as $20 billion of damage, and what that means for the bank's monetary policy.

Bollard cut the official cash rate half a percentage point to 2.5% in March in response to the Feb. 22 quake which devastated Christchurch. This month he kept the rate on hold, and hinted that rate hikes may begin at the end of this year.

Traders are betting he will raise the OCR by 61 basis points in the next 12 months, based on the Overnight Index Swap curve.

The bank said a 10 per cent appreciation of the kiwi dollar from its level at April 30 would cost it $210 million, though a 10 per cent depreciation would bolster its coffers by $256 million.

The kiwi dollar has gained 1.9 per cent against the greenback, recently trading at 82.47 US cents since the end of April.

It is up 4.1 per cent to 71.12 on the trade-weighted index of major trading partners' currencies, the bank's preferred measure of the kiwi.