Reserve Bank of New Zealand Governor Alan Bollard held the official cash rate at a record low 2.5 per cent and said interest rates will rise "over the coming months" as the economy recovers.
The kiwi dollar fell as Bollard said the tightening may be more modest than in previous cycles.
The economy is expected to recover in line with or slightly faster than Bollard forecast in March, he said today "We expect to begin removing policy stimulus over the coming months, provided the economy continues to evolve as projected." He has previously said rate hikes may begin in the middle of the year.
"The RBNZ has given itself room to manoeuvre, still leaving a lot of wriggle room with its signal it expects to begin removing stimulus over coming months," said Nick Tuffley, chief economist at ASB. While the wording has been tweaked in the latest statement, "effectively that signal is still "around the middle of 2010."
The kiwi dropped to as low as 71.71 US cents from 72.02 cents immediately before the announcement. It was recently at 71.82 cents.
Bollard said he may not have to raise rates as much as in previous tightening cycles because the "wedge" between the OCR and lending rates will make hikes "more effective than in the past."
He has kept the OCR at a record low for 12 months after he slashed interest rates to revive the economy from its worst recession in 18 years.
The Reserve Bank forecasts the 90-day bank will rise to 3.3 per cent in the September quarter, and traders have been split over whether Bollard will tighten monetary policy in June or July after first-quarter inflation came in at 0.4 per cent, below market expectations.
Bollard will probably lift rates by 25 basis points in his first hike, then assess how the market reacts, before deciding whether to return to more normal policy settings more aggressively, said Stephen Toplis, head of research at Bank of New Zealand.
"We're in a very unstable environment and nobody wants to be too definitive about anything," Toplis said.
Traders have increased their expectations for increases in the OCR, pricing in 191 basis points over the next 12 months, according to the Overnight Index Swap curve, compared to 185 points before the statement.
New Zealand's economy climbed out of recession in the middle of last year as returning expatriates and incoming migrants stoked demand for housing amid a decline in new construction, while dairy prices bounced back from a slump in July and have underpinned confidence in the farming sector.
Bollard said the country's strong export earnings supported its faster-than-expected recovery, and was something he persistently said was necessary for sustainable economic growth last year.
"Trading partner activity has recovered more quickly than we expected," he said. "Consistent with this, export commodity prices have increased close to their 2008 peak."
Still, consumers are continuing to look to the future as a 10-year high unemployment rate of 7.3 per cent continues to sap their appetite to start buying big ticket items. The ANZ Roy Morgan Consumer Confidence survey last week showed consumers are more optimistic about the future than they are about the present, and Bollard said households were still "cautious" amid a subdued housing market and credit growth in today's statement.
The central bank expects inflation to stay within its target band of between 1 per cent and 3 per cent in the medium term, though today's increase in tobacco excise tax put more upwards pressure on the consumer price index, adding 0.2 percentage points in the second quarter, according to ANZ New Zealand economists.
The latest National Bank Business Outlook, out yesterday, showed confidence has stayed buoyant after its rebound through the latter half of 2009, and companies are beginning to get more optimistic about their hiring and investment intentions. Bollard flagged weak business spending and deleveraging as signs that there was room for the recovery to pick up pace.
Though businesses' pricing intentions remained stable at a net 26 per cent of respondents expecting to increase their prices over the coming year, expectations for inflation edged up to 2.67 per cent from 2.64 per cent in March as companies prepare for Bollard to begin tightening monetary policy.
That will bring New Zealand into line with its biggest trading partner across the Tasman which has been on a tightening regime since October last year.
The Reserve Bank of Australia has hiked its target cash rate four times, and yesterday's data showing a faster than expected pace of inflation increased the prospect of another rate hike by the RBA next month. At 4.25 per cent, the Australian benchmark rate is currently 175 basis points over New Zealand's OCR, a record spread in Australia's favour.
Meanwhile, the world's largest economy is still in damage control, with the Federal Open Market Committee keeping the Fed Fund at a target of between zero and 0.25 per cent. While it reiterated rates will remain low for an extended period, it was more upbeat on America's housing and labour markets.
See the latest OCR changes here
