Stuck between a rock and a hard place

Alan Bollard

Petrol bowsers and ballot boxes will loom large in Alan Bollard's mind as he prepares to deliver his quarterly verdict on the economy next Thursday.

Economists expect the Reserve Bank Governor to leave the official cash rate on hold at 6.75 per cent. The interest will be in what he says about the economic outlook and what that signals about the future track of interest rates.

They expect to hear a lot about the impact of the surge in oil prices on growth (downward) and on inflation (upward), but on the fiscal and monetary policy implications of next Saturday's poll a decorous silence.

Petrol prices have risen about 30c a litre, or 27 per cent, since the last monetary policy statement three months ago.

Bank of New Zealand economist Craig Ebert said surging oil prices accentuated the dilemma the Reserve Bank Governor already faced: high and rising inflation yet slowing economic growth.

"Add to that the pressure from fuel prices on the external accounts and the associated vulnerability of the dollar, and the bank could be forgiven for feeling it is between a rock and a hard place."

The BNZ expects fuel prices to push inflation towards 4 per cent, well outside the Reserve Bank's 1 per cent to 3 per cent target band.

"The bank, at this point in the cycle, will be most relieved by anything promising to take the heat out of domestic demand. In this respect, petrol prices could well do the work that interest rates might otherwise have to do," Ebert said.

John McDermott, chief economist of ANZ and the National Bank, said the spike in petrol prices was hitting the economy when money was already being siphoned out of it through lower export earnings and higher mortgage payments.

Not only does more expensive petrol leave consumers with less to spend on other things, it also squeezes firms' profit margins. "That represents a risk to employment and investment - the very sources of growth required to keep the economy expanding," McDermott said.

He thinks higher oil prices could shave 0.5 per cent off growth next year.

"We now expect GDP growth closer to 1.5 per cent than 2 per cent over 2006."

He says the economy has slowed to a "stall" speed where it is more vulnerable than normal to an adverse shock.

Westpac economist Nick Tuffley said the increase in petrol prices so far this year was equivalent to about $500 a year out of the average household's pocket.

Tourism earnings are reliant on visitors travelling long distances, so higher travel costs compound the impact of a high dollar on that sector.

And firms in the transport sector are facing increasing pressure on their profit margins. "To the extent that pain is passed on, other businesses will experience higher costs."

A slowing economy makes it harder for firms to pass on increases in their costs.

Statistics New Zealand figures on producer prices two weeks ago showed increasing pressure on business' margins, with input costs rising 4.7 per cent over the past year, not least because of energy, while output prices rose 3 per cent.

First NZ Capital economist Jason Wong said in the early stages of the ramp-up in oil prices firms were able to absorb the cost increases in their margins. "But that is no longer the case after such a prolonged and significant increase."

It is "second round" effects, where higher energy costs trigger wide This is equivalent to about $500 a year out of the average household's pocket.

Higher oil prices are expected to push inflation towards 4 per cent.

They could also shave 0.5 per cent off growth next year.

spread price rises and flow through to higher wage inflation, that worry the Reserve Bank.

Its bottom line is always to keep "inflation expectations anchored", that is, to maintain confidence among wage and price setters that they are operating in a low inflation environment.

In late 2000, inflation spiked briefly to 4 per cent, driven by oil prices, only to pass quickly out of the system and leave inflation expectations securely anchored.

Early in 2001, the bank started cutting interest rates in response to a worsening world economy, even with inflation at 4 per cent.

But this time, the environment is more challenging. For one thing, the dollar is high and expected to fall, making oil and other imports more expensive, whereas it was starting to rise from its lows in 2000.

And the labour market is extremely tight, so that high inflation should get more traction in wage agreements.

McDermott expects inflation, now 2.8 per cent, to rise to 3.8 per cent, with 0.9 per cent of that coming from petrol.

But he said Bollard should be more mindful of the growth ramifications of higher petrol prices than the inflation implications.

"Hitting the economy with higher interest rates at this stage of the economic cycle could prove disastrous."

The last time New Zealand had a recession, after the Asian crisis, it was partly because of the Reserve Bank mishandling its response.

"Inflation will admittedly remain uncomfortably high over the coming year. But we struggle to see how New Zealand will be the only country where the inflation bogey is unleashed, in a world where globalisation rules."

Deutsche Bank chief economist Ulf Schoefisch said that so far buoyant prices for export commodities - meat and dairy products in particular - had provided an offset to rising international energy costs.

But commodity prices have fallen in the past three months in ANZ's commodity price index.

Schoefisch said trends in food commodity markets suggested a small downward correction in prices over the next year.

If that was combined with oil prices staying at present levels, it could push the current account deficit well above 8 per cent of GDP and pull economic growth from a rate of about 2 per cent now to 1 per cent.

A current account deficit so wide and growth so weak should bring the exchange rate down.

"Everyone in the currency market can see where we are heading. Even though commodity prices are easing a little, it is the interest rate level that is holding things up," Schoefisch said.

"Last month was a record for eurokiwi issuance, nearly $2 billion. It's anyone's guess how much uridashi issuance there was but it could be as much again."

Eurokiwi and uridashis are debt instruments denominated in New Zealand dollars raised from retail investors in Europe and Japan attracted by interest rates here and prepared to take the risk the exchange rate will move against them by the time the debt is repaid.

Schoefisch said the Reserve Bank might eventually have to lower interest rates simply to get the currency down "but that's a story for down the track.

"At this stage, we believe the Reserve Bank is giving the inflation and growth effects [of higher oil prices] equal weight. As a result, we don't expect any change in its relatively hawkish rhetoric over the near future. However, we forecast the economy to weaken sufficiently by early next year to contain inflation risks and allow the bank to embark on an easing cycle starting in March next year."

In doing its economic forecasts, one of the factors the Reserve Bank has to allow for is how stimulatory or contractionary the Government's fiscal policy - its taxation and spending plans - will be.

In the past year, fiscal policy had a contractionary effect equivalent to about 1.5 per cent of GDP as money poured into the Government's coffers faster than it poured out.

In the May Budget that was forecast to switch to an expansionary impetus over about 0.75 per cent of GDP this year, rising to 1.5 per cent next year and then 1.2 per cent the year after.

Those are the assumptions that will underpin next week's monetary policy statement too.

Bollard, as a former Treasury Secretary, may well have a view of how much additional stimulus National's tax cuts or Labour's higher spending and family tax relief package would generate on top of what is already in the pipeline.

But two days before the voters have their say, he is unlikely to be be forthcoming on that point.

Wong said the economic impact of easier fiscal policy depended on whether the easing came via increased Government spending or tax cuts.