Inflation signs lift chance of rate rise

The chances of another Reserve Bank interest rate increase have risen after new evidence of inflationary pressure in the economy.

ANZ National Bank economists are now predicting Reserve Bank Governor Alan Bollard will raise the official cash rate 25 points to 7.5 per cent on October 26 after the Institute of Economic Research's quarterly survey of business opinion was much stronger than expected yesterday.

A net 19 per cent of firms expect the economy to get worse - down from a net 44 per cent of that view in June.

The net figures are those who expect improvement, minus those who don't.

"The decline in petrol prices has obviously been more important to businesses than the stronger currency or the possibility of another rate hike from the Reserve Bank," said Deutsche Bank chief economist Darren Gibbs.

"The economy, I guess, is thumbing its nose at the bank."

The survey follows several signs that households are not pulling their horns nearly as fast as the Reserve Bank would like when inflation has been above 3 per cent for a year and is forecast to stay there for another year.

Bollard said last month that another rate increase might not be needed as long as the economy weakened as expected, without "upside surprises in a sustained sort of way".

But since then, Quotable Value has reported house prices still rising at double-digit annual rates in the September quarter.

Fierce competition among banks is reducing the increase in mortgage rates as fixed-term loans are rolled over, and petrol prices have fallen about 33c a litre over the past two months, leaving people with more to spend on other things.

And now the business opinion survey shows another rise in firms hiring intentions and a very low reading for spare capacity in manufacturing and building.

After declining for 18 months, the capacity measure, closely watched by the Reserve Bank, has jumped sharply and is just below its record high.

The increase was spread across manufacturers and builders and evident among exporting and non-exporting firms alike, institute director Brent Layton said.

As well, firms by a net 5 per cent expect their own activity to rise over the next three moths.

Their investment intentions improved, and a net 6 per cent expect to take on more staff. That is the highest reading for a year.

Following strong employment growth and evidence of labour hoarding in the first half of a year, the survey casts doubt on economists' assumptions that rising concerns about job security will prompt households to rein in spending and boost savings.

ANZ National Bank chief economist Cameron Bagrie said: "We think the Reserve Bank could afford to wait, but it's about balancing risks and it will be feeling uncomfortable about the risks to inflation."

Bagrie is on the road talking to his bank's clients, and he says feedback about their inflation expectations is disturbing.

"Everybody is telling me inflation will be running at 4 per cent over the next year, which is not what the Reserve Bank wants to hear."

Westpac chief economist Brendan O'Donovan said that if it were only a matter of capacity use and the mortgage wars, another interest rate rise would be certain.

But he thinks the recent rebasing of the consumers price index, which gives less weight to housing costs and more to petrol, will have enough of a downward effect on inflation to stay Bollard's hand.

"Without that I would say a rate hike is guaranteed. With it, it is a knife-edge decision."

Although only a minority of market economists expect another official cash rate rise in this cycle, money market pricing implies a two-to-one chance of a hike by the end of the year.