Reserve Bank Governor reverses the trend

By BRIAN FALLOW, economics editor

Reserve Bank Governor Don Brash has started to raise interest rates again, wrong-footing most analysts and disappointing business groups and unions.

Citing a surprisingly buoyant domestic economy and a less threatening global outlook, Brash yesterday took back a quarter of the one percentage point in rate cuts taken out as insurance after the September 11 attacks. The official cash rate rose from 4.75 per cent to 5 per cent.

Brash considers that, with little or no slack in the economy and inflation expected to hover near the top of his target band of 3 per cent, the easing needs to be reversed fairly smartly.

The bank's monetary policy statement projects 90-day bank bill rates, off which floating mortgages are priced, to peak around 6.25 per cent in the first half of next year.

But financial markets predict rates will rise faster and further.

Most market economists had expected Brash to wait until May before raising rates, but financial market pricing before yesterday's announcement reflected a less-sanguine view.

Even so, the announcement triggered a further round of rises in wholesale interest rates, especially at the short end. The markets are now pricing in at least another 75 basis points by the end of June and rates of 6.5 per cent by the end of the year and 7.5 per cent by the end of next year.

Asked what he gained by moving now rather than waiting until May, Brash said: "Probably that we can move in smaller steps. The argument for moving now is so compelling that to have waited longer would have simply built up a bigger problem."

But Deutsche Bank chief economist Ulf Schoefisch said the markets had already done the tightening work. Brash could have underpinned that verbally.

By raising rates he had fuelled a further flurry of wholesale rate rises, which was at odds with his supposed gradual approach.

The Reserve Bank pointed to the fact that the international consensus forecasts this month indicate a more rapid recovery. The consensus pick for growth in the United States this year is 2.1 per cent, compared with 0.9 per cent in January.

But ANZ bank chief economist David Drage said there was no guarantee the world recovery would be particularly strong, export commodity prices were likely to weaken further and the recent strength of the New Zealand dollar removed some of the buffer offsetting that price decline.

On the domestic front, the Reserve Bank points to unexpectedly rapid rebounds in consumer and business confidence, and the strength of retail sales, the housing market and employment growth. It is worried about inflation expectations.

"Headline inflation has been at or above the top of our inflation target for much of the last 18 months and for a number of reasons that seems likely to be true for most of this year," Brash said.

But the bank notes that wage demands have been moderate and the proportion of firms in business confidence surveys declaring an intention to raise prices had fallen over last year.

"It illustrates that we are not facing a serious problem at the moment," Brash said. "It's a moderate threat that inflation will increase unless we increase interest rates. We are operating close to full capacity and there are plenty of drivers which lead us to think that will continue and potentially accelerate in the absence of some increase in interest rates."

The bank believes the turnaround in migration will in the short term boost the demand side of the economy more than the supply side, and so add to inflation pressures.

The US Federal Reserve yesterday left rates steady but switched from an easing to a neutral bias.