The Reserve Bank said it had left its official cash rate (OCR) unchanged at 2.5 per cent but left no clues as to when the next tightening cycle would begin.

Market expectations are for the bank to start increasing rates early next year in order to stave off expected inflation pressures.

"The bank will increase the OCR as needed in order to keep future average inflation near the 2 per cent target midpoint," Reserve Bank Governor Graeme Wheeler said in a statement.

The Reserve Bank said it had left its official cash rate (OCR) unchanged at 2.5 per cent but left no clues as to when the next tightening cycle would begin. Market expectations are for the bank to start increasing rates early next year in order to stave off expected inflation pressures.

Annual CPI inflation increased to 1.4 per cent in the September quarter and inflation pressures are projected to increase, Wheeler said.


The extent and timing of such pressures would depend largely on movements in the exchange rate, changes in commodity prices, and the degree to which momentum in the housing market and construction activity spilled over into broader cost and price pressures, he said.

Read the full text of the Monetary Policy Statement here

The bank expects the country's strong house price inflation to persist for longer than it previously thought as low interest rates, rising net migration and a supply shortage continue to drive the market.

New Zealand house prices have increased 18 per cent in the past two years, driven largely by a lack of supply in the country's two biggest cities Auckland and Christchurch, and prompting the Reserve Bank to impose restrictions on the level of high loan-to-value ratio lending banks can write as a means to stifle demand. Governor Graeme Wheeler wants to discourage riskier lending, which could put the financial system under stress if the economy was hit with an unexpected shock.

The bank expects to trim between 1 and 4 percentage points from the pace of house price inflation within the first year of implementation, though migration pressures and low interest rates mean it now sees strength in the market lasting longer than it predicted in September.

"Quarterly house price inflation is expected to remain at around current levels in early 2014," the bank said in its monetary policy statement.

As the LVR restrictions kick in, net inbound migration ebbs and interest rates rise, that pace of growth is expected to slow.

The fear for the Reserve Bank is that house price inflation persists and households react by increasing consumption, putting upwards pressure on consumer prices and meaning the bank would have to raise interest rates faster.

The Reserve Bank expects demand for housing will cool when it lifts the benchmark rate next year, particularly if people are basing current buying decisions on the view that rates will stay lower for longer.

When the bank does start tightening monetary policy, it will likely have a staggered effect on home lenders, with borrowers continuing to switch to fixed rates, though largely for one-year terms.

At the end of October, about 43 per cent of mortgages were on floating rates, down from 56 per cent a year earlier. Another 30 per cent of borrowers are on one-year terms.

Borrowers switched out of fixed rates in the wake of the global financial crisis, as New Zealand's central bank joined the world in slashing interest rates, making it more attractive to go on a floating rate.

Stronger terms of trade could drive interest rates up further

Strong commodity prices, particularly for dairy products, could drive up interest rates more than currently expected if they continue to keep the terms of trade at elevated levels, the Reserve Bank says.

In an alternative scenario in today's monetary policy statement, the bank projected a more aggressive tightening cycle if global demand for New Zealand exports keeps commodity prices high and maintains an elevated terms of trade. The terms of trade were at a 40-year high in the September quarter as surging dairy prices, primarily driven by Chinese demand, raised the value of export receipts.

If proposed reforms by Chinese authorities go ahead, that could benefit New Zealand's export products over the coming decade, putting the terms of trade on an increasing trajectory rather a decline, as assumed in the bank's main forecast.

That in turn would increase pressure on productive resources and lead to stronger non-tradables inflation, needing a more aggressive policy response from the Reserve Bank.

The improving outlook would also drive up the currency, though that wouldn't detract from bigger interest rate hikes as the better trade environment would stoke domestic demand.

Financial markets have fully priced in a rise in the official cash rate from 2.5 per cent to 2.75 per cent by the end of March next year and at least a full percentage point by late 2014, with more to come beyond that.

A Reuters poll of 16 banks and other economic forecasters found 12 of them expect the first increase in the OCR in the March quarter next year.

This week the bank announced a backdown on the original policy, saying that it would now exempt residential construction loans from the LVR restrictions.

The bank said it had consulted with the building industry and banks on the impact of LVR restrictions - also known as speed restrictions - on residential construction activity.

While high LVR construction lending is only around 1 per cent of total residential lending, it finances around 12 per cent of residential building activity.

See a Reserve Bank question and answer page on the new home LVR exemption here.

Builders welcome Reserve Bank loan backdown

Reserve Bank buckles - new homes exempt from loan rules

- APNZ / BusinessDesk