KEY POINTS:
Reserve Bank governor Alan Bollard at the end of yesterday's quarterly briefing on the economy, jokingly wished everybody "a very happy and cautious spending Christmas".
While he left official interest rates unchanged, it was far from a jolly occasion.
Dr Bollard said that interest rates, already the highest in the developed world, were going to remain where they are for longer and were unlikely to fall next year.
Already intense inflation pressures had increased significantly since the last quarter, with oil prices 30 per cent above previously anticipated levels.
Petrol, food, Government spending from bulging treasury coffers rising wages due to a tight labour market, are all contributing.
Dr Bollard stressed that Government plans to cut taxes to the tune of $1.5 billion in early 2009 would clearly add to pressure.
On top of this, the Government's Energy Strategy to cut greenhouse gases were not even factored into calculations. Economists estimate these will add around one percentage point to the inflation rate over two years.
Independent economist Donal Curtin summed it up, saying "Everything's horrible."
Without counting the Energy Strategy costs, which will put up everyone's power and petrol bills, inflation is picked to rise to 3.5 per cent next year, and be above the 3 per cent target all year.
Inflation has mostly been 2.5 per cent or above for 3-1/2 years.
When the present tightening cycle began four years ago, Dr Bollard doubted bank lending rates would hit double figures this cycle, as they had in others, because of increasing acceptance of the low inflation framework.
That hope has proved vain and we seem mired in a bog of inflation above that of our trading partners, high interest rates to try and quell it, an overvalued dollar because of that, and consequent economic growth below potential and that of our partners.
Westpac chief economist Brendan O'Donovan believes the Reserve Bank is too optimistic on inflation which he thinks will track "considerably higher" than Dr Bollard has forecast.
"We still see huge upside risk to the bank's inflation forecasts coming particularly from Energy Strategy costs, oil prices, food prices, wages, inflation expectations and their GDP track.
He believes Dr Bollard will have to hike rates even higher.
"We continue to expect two hikes next year unless the global credit market situation begins to look like it will severely impact of NZ's real economy," Mr O'Donovan said.
ANZ chief economist Cameron Bagrie believes there is a danger of a return to the dreaded vicious inflation cycle of the 1970s and '80s where workers demanded compensation for rising costs, businesses had to hike prices as labour costs rose and so on.
That, he told Radio NZ, is every central banker's nightmare.
The environment is conducive to that scenario because the labour market is so tight - employers are much more likely to accede to workers' demands for fear of losing them and not finding replacements. The threat of workers decamping to Australia is real.
Mr Bagrie said if that kind of inflation genie gets out of the bottle, Dr Bollard will have no choice but to crunch the economy.
One event that may allow him to escape the nightmare, replacing it with a worse one, is a global meltdown.
That is quite possible as a result of the subprime mortgage/credit crunch crisis that has seen finance institutions write off losses of over US$400b.
Other central banks around the world, led by the US Federal Reserve, have been cutting rates and pumping billions into financial systems to stave of a meltdown.
Mr Bagrie says the global economy is very fragile and New Zealand's economy could unwind very quickly.
Assuming that doesn't happen, he said the only way to bust the vicious inflation cycle is for productivity to improve.
Such growth is critical to sustain higher wages relative to our trading competitors and a high growth economy.
Productivity growth in the 1990s was reasonable but in the 2000s has been dismal - averaging 0.7 per cent.
New Zealand's productivity is about as far behind Australia's as our cricket team is behind theirs, because of low investment here.
Skill shortages, poor infrastructure and the inability to achieve economies of scale due to the small size of the market have also contributed.
Investment that should improve productivity has picked up strongly this year with spending on plant and machinery up 45 per cent in the year to June on what it was five years ago.
However, Mr Bagrie said that to get productivity growth up to the 2.5 per cent level of the 1990s "something needs to happen".
"We are certainly seeing a few steps in the right direction. Is it enough? I'm not convinced."
- NZPA
