Bollard's hawkish move puzzles analysts

Reserve Bank Governor Alan Bollard is forecasting annual growth of 4.2 per cent in the year to March. Photo / Mark Mitchell

Reserve Bank Governor Alan Bollard has signalled an earlier start to the tightening cycle - raising the exchange rate, wholesale interest rates and eyebrows in the process.

As expected he left the official cash rate at the historic low of 2.5 per cent it has been since April. But he changed the language about when he might start to raise it from October's "the second half of 2010" to "around the middle of next year".

The new language endorses where market pricing had moved to, but predictably it was taken to indicate a more hawkish stance than he took six weeks ago.

As a result the kiwi dollar jumped by more than a cent to around US72.5c against the greenback and the swaps market is pricing in rate hikes in March and April and an OCR of 4.5 per cent by the end of the year. The dollar closed at US72.38c.

It has left market economists scratching their heads as to why Bollard went to the trouble in October of pushing back market expectations of when he would start to raise the OCR only to reverse the signal.

"It felt like they almost had the dollar where they needed it, easing back and the market reluctant to push it higher," said Bank of New Zealand economist Stephen Toplis."Why not just leave things as they were?"

That is especially so as the central bank was at pains to list a string of reasons why there is no pressing need to raise the rate.

Monetary conditions have already tightened, with a higher exchange rate and higher long-term interest rates.

In response, borrowers have been borrowing for shorter terms, which will give the bank more traction when it does start to raise rates, compared with when the overwhelming bulk of home loans were fixed for longer periods.

While the OCR is 2.5 per cent, banks' cost of funds is around 4 per cent as they scramble for deposits. The spread between OCR and the cost of funds is unusually wide, with mortgage rates wider still.

The forecasts underlying the rate decision are rosier than those in the September monetary policy statement on the international and home fronts.

Growth rates among New Zealand's trading partners are expected to return to levels prevailing in the middle of the decade over the next two years.

For New Zealand the bank is now forecasting annual growth of 4.2 per cent in the year to March 2011. "But it is still late 2010 before we see the ground lost in the financial crisis made up," Bollard told Parliament's finance select committee.

Underpinning the rebound in GDP is a stronger outlook for household spending than the bank expected three months ago.

It sees unemployment peaking at 6.7 per cent in the middle of next year, not far above its present 6.5 per cent.

It confesses to being surprised at the rebound in house prices, but is not too concerned yet. It expects house price inflation to hit double digit levels by March next year then to fall towards 2 per cent as more people opt to sell and more houses are built.

It also expects some pressure to come off as resurgent growth in Australia encourages more people to leave for there.

But it said a key uncertainty was how much higher house prices would eventually be reflected in increased consumer spending. It notes the disconnect between rising housing prices and household debt levels which are hardly increasing. That suggests borrowers are using the respite in mortgage rates to increase repayments of principal to strengthen their balance sheets.

"So we are not getting worried about a credit-driven housing bubble," Bollard told the MPs.

While the bank is forecasting a stronger outlook for household consumption than three months ago, it is still relatively subdued compared with previous recoveries, he said.