OCR: rates left on hold at 2.5pc

Reserve Bank Governor Dr Alan Bollard. Photo / Mark Mitchell

Reserve Bank Governor Alan Bollard held the official cash rate at 2.5 per cent, as expected, saying Europe's sovereign debt crisis and the weakness in global financial markets continue to threaten the local recovery.

"There is a real risk that the European sovereign debt crisis could cause a further slowing in global activity, putting downward pressure on New Zealand's commodity export prices," Bollard said in a statement.

"Given the ongoing global economic and financial risks, it remains prudent to continue to keep the OCR on hold at 2.5 per cent for now."

Since the last monetary policy statement in September, New Zealand's sovereign credit rating has been downgraded by Standard & Poor's and Fitch Ratings due to the size of the country's external debt, though Treasury the Reserve Bank are expecting household savings to improve as people use the record low interest rate to repay debt and improve their personal balance sheets.

Still, a softer than expected 0.4 per cent third quarter increase in the consumer price index helped quell fears inflation is creeping into New Zealand's economy, and Bollard said "underlying inflation is settling near 2 per cent," which gives him room to keep rates lower for longer.

"On domestic conditions alone we think the RBNZ should be lifting rates, and we still expect it to take back part of the emergency cut by year-end," HSBC chief economist Paul Bloxham said in a note before the release.

"The clear downside risk to this outlook comes from the global economy and financial developments in Europe in particular."

Earlier this year, Bollard indicated he was keen to remove the extra stimulus he added in response to the February earthquake, though that was put on hold as financial markets tumbled after the United States' credit rating was downgraded and the Euro-zone struggled to come to grips with the high level of debt among some of its members.

If Europe's woes seep into the global financial system, New Zealand's bank funding costs could increase over the coming year, Bollard said, repeating his warning from last month's statement.

Still, European leaders reached agreement on Wednesday to introduce a 9 per cent tier one capital ratio for the region's banks in an effort to shore up the banking system. That leaves the size of the European Financial Stability Fund in dispute, along with how much the Euro-zone's members will have to pay to bail-out the heavily indebted Greece to prevent the Mediterranean nation's problems from spreading.

Bollard's decision to hold comes a day after the National Bank Business Outlook showed businesses are getting less optimistic about the country's economic recovery, with just a net 1.6 per cent of firms expecting to be more profitable over the coming year.

A downgrade in Fonterra's forecast payout to farmers added to the local woes, with the dairy exporter cutting 45 cents per kilogram of milk solids for the 2011/12 season payment, and blaming the strong New Zealand dollar and weaker commodity prices.

Bollard said domestic economic activity is expanding at a "modest pace" and local business confidence has dimmed in recent months. Still, the rebuild of Christchurch will "provide significant impetus for demand" and stoke the economy when it finally begins in earnest.

That rebuild is expected to start later and take longer than previously forecast, and earlier this week the Treasury joined the Reserve Bank in lifting its estimated cost to $20 billion from $15 billion predicted in May.

If the global downturn's impact on New Zealand is only mild, "it is likely that gradually increasing pressure on domestic resources will require future OCR increases," Bollard said.

Last month, he said any rate hikes will be over the coming year so the Reserve Bank can assess the impact of the global downturn. Before the announcement, traders were betting Bollard would hike the OCR by just 31 basis points over the coming 12 months, according to the Overnight Index Swap curve.

Last month, the central bank reined in its forecast track for the 90-day bank bill through 2012 and 2013, with the rate settling at 4.3 per cent in the December quarter next year where previously it was seen climbing to 4.9 per cent by the end of 2013 in the June forecast. The rate is often seen as a proxy for the track of the OCR.

See the history of the Official Cash Rate here.