The potential inflationary effect of climate change costs on power and petrol could be a major headache for the Reserve Bank in future, Westpac economists said today.
The bank said the Government's climate change policy initiatives "couldn't have come at a more difficult time for the RBNZ" whose 1-3 per cent inflation band target was already at the high end.
It suggested higher electricity and petrol price add between 0.3 and 1 percentage point per annum to the consumer price index over the next three years.
Westpac said it begged to differ with the Government's conclusion that the economic impact on its new emissions trading system would be small.
"Modelling the impact of government policy is difficult at the best of times but even more so in this case, given that the key price indicator has yet to be set (the carbon price)."
Westpac said that although much of the Government's work was based on a carbon price of $15/tonne, international estimates ranged to as high as $200/tonne.
Work by the Electricity Commission suggested $45/tonne was needed to make renewables-based generation break.
"Certainly recent commentary amongst Government officials suggests the consensus has moved to a carbon price of around $30-$40/tonne."
Because carbon prices were hard to forecast, electricity and petrol price increases also ranged widely, Westpac said.
A carbon price of $15/tonne would lift petrol prices by 10 per cent and residential power bills by 7 per cent, while $25/tonne would rise them by 12 per cent and 11 per cent respectively.
A carbon price of $50/tonne would make petrol prices jump 16 per cent and electricity by 20 per cent.
There would also probably be "second round" effects on inflation as the higher power and petrol prices impacted on production costs and, thus, consumers.
Petrol levies, which could be applied by local councils from next year, would also add to the Reserve Bank's woes.
Best practice for central banks was generally to ignore the "first round" effects of one-off tax changes and deal with the second round effects, Westpac said.
"However the RBNZ may not have as much scope to be fully accommodative because of the high starting point for inflation and the risk that the phased tax changes bid up inflation expectations further."
Other upside risks to inflation included higher oil prices, greater fiscal stimulus, more resilient international growth, a tighter labour market, persistently high food prices, and dairy farmers spending their cash windfall.
Only a marked deterioration in credit markets or double-digit declines in house prices would avert the Reserve Bank's inflationary problem, the bank said.
"We remain comfortable with our out-of-market call for two additional interest rate hikes next year."