Editorial: Benign view on OCR could go out window

Reserve Bank Governor Alan Bollard. Photo / Mark Mitchell

The Reserve Bank's lifting of the official cash rate by 25 basis points, after holding it at a record low of 2.5 per cent for 13 months, sets the scene for a gradual series of interest-rate rises over the next couple of years.

Money markets expect this tightening by way of small steps to prompt an official rate of 4 or 4.25 per cent by this time next year, and further increases to about 5 per cent by the end of 2011.

We should not, says Governor Alan Bollard, expect the rate to rise as far as the 8.25 per cent peak of the previous cycle.

Hopefully not, but several things could knock the ship off course. One is rising inflation, the central bank's core concern.

Another is whether households will be more minded to increase private savings after the global recession, rather than, as in the last economic cycle, exhibit an unhealthy appetite for debt. A third is a further international shock.

The Budget increase in the goods and service tax and the impact of the emissions trading scheme on fuel and electricity prices are expected to propel the consumer price index to 5.3 per cent in next year's June quarter.

Dr Bollard is taking a benign view of this, assuming the spike will be a one-off occurrence and will not have a persistent effect on inflation expectations and price and wage-setting behaviour.

He is also, more questionably, assuming households will continue to be cautious and, more particularly, that the housing market will be subdued, with prices not recovering their 2007 peaks, in real terms, over the next three years. In the short term, that appears a reasonable view.

The most recent Quotable Value statistics reveal a weakening of property values for the first time in 14 months, reflecting a general lack of buyer confidence.

But as optimism picks up and a broader-based recovery gathers pace, things may change. This year, the tax working group outlined the degree to which investors in rental property were "systemically under-taxed".

The Budget response - an end to depreciation claims on rental housing and alterations to the tax rules governing loss attributing qualifying companies - has done little to downgrade the attractiveness of such investment.

That has dangerous implications. The Government, in support of the Reserve Bank, should not only be practising restraint in terms of tight fiscal management but should take every chance to instil the same characteristic in individual households.

Its policy on rental housing fails in that respect. To compound the problem, alternative, equally attractive investments remain thin on the ground.

With nothing much changed, this economic cycle could, therefore, develop similarly to the last. Groups representing landlords breathed a sigh of relief after the Budget.

All too soon, investors could pick up on this and return to the property market. Confident of untaxed capital gains, they could resume their borrowing and spending on rental homes, prompting another round of property price inflation.

The official cash rate might, indeed, prove a stronger deterrent this cycle, thanks to the likes of more mortgages being on floating rates and higher bank funding costs. But will it be enough to prevent the all-enveloping danger of another housing bubble?

If this, or an international shock, occurs, the Reserve Bank will have no option but to put its foot more firmly on the economic brake. Small-step lifting of the official cash rate would go out the window, as would the prospect of a neutral rate.

Restraint will be a key if this outcome is to be avoided. Dr Bollard will hope that he does not rue the squandering of an important opportunity to instil this.

See the text of Governor Alan Bollard's statement here.
See the full Monetary Policy Statement here.