Inflation pressures a growing spectre

Inflation fears are expected to outweigh concerns about economic growth in the Reserve Bank's monetary policy statement this Thursday, with market economists expecting no change to the official cash rate.

But even though the Reserve Bank is expected to maintain its tough stance on the inflation and interest rate outlook, it is likely to revise down its forecast for short-term economic growth.

Westpac's Nick Tuffley expects the growth forecast for the year to March 2007 to be closer to 1 per cent than the 1.5 per cent published in the March statement.

When Reserve Bank Governor Alan Bollard reviewed the official cash rate (OCR) in April (at 7.25 per cent it is among the highest in the developed world) he acknowledged that the economy had weakened more rapidly than the bank expected but said short-term inflation pressures had intensified.

In the housing market, turnover has continued to slow, as has the trend for building consents, while house prices show signs of starting to level off.

Although house prices are not part of the CPI, they matter for monetary policy because in a period of rapid house-price inflation, people are more inclined to borrow and spend on other things on the strength of their increased housing wealth.

The bank is counting on that "wealth effect" on consumption being turned off as higher effective mortgage rates cool the housing market.

In the March quarter, retail sales adjusted for inflation, grew at the weakest rate for four years. Business investment in plant and machinery is also weaker.

But the growth indicators are not all pointing south.

Net immigration is rising again, wages growth is strong, and the Treasury estimates that fiscal policy will provide a net boost to demand in the economy of about 1.5 per cent of GDP over the year ahead.

Tuffley said the disinflationary drag of anaemic economic growth would eventually dominate the Reserve Bank's decisions, but not until late 2006. "The longer the wait the harder the fall in economic growth and interest rates."

But in the meantime, all 14 economic forecasters surveyed by Reuters expect the OCR to remain on hold on Thursday and all but six expect no cut until the first quarter of next year.

Financial markets were pricing in only a one-in-three chance of a 25 basis point cut by the end of this year, Tuffley said.

Bank of New Zealand economists think annual inflation is running at 3.7 per cent right now and that while that is about as high as it gets, they do not expect it to fall back below 3 per cent until early 2008.

The slowdown in domestic economic activity that is now clearly well under way will relieve inflationary bottlenecks on the non-tradeables side, but so far the improvement has been modest.

So far this year the exchange rate has been about 2.5 per cent lower on a trade-weighted basis than the bank assumed in March.

But the weaker dollar pushes up the cost of imported goods at a time when world oil prices are at near-record highs.

Inflation has been above the top of the bank's 1 to 3 per cent target zone since the middle of last year, even though for most of that period prices of imported goods have been restrained by a high dollar.

The increase in overall headline inflation will occur against a backdrop of a tight labour market, with unemployment low by historical and international standards and workforce participation high.

This raises the risk of inflation becoming more persistent as higher inflation expectations influence wage and price-setting behaviour.

Bank's outlook

* Lower growth expectations

* High inflation risks

* A falling dollar and high oil prices

* Labour market remains tight