Bank boss keeps eye on expansion

Reserve Bank Governor Graeme Wheeler. Photo / Mark Mitchell

Returning interest rates to more normal levels will help make the economic expansion now under way more sustainable, Reserve Bank Governor Graeme Wheeler says.

Wheeler told the Canterbury Employers' Chamber of Commerce yesterday that increased inflation pressures and the rise in interest rates necessary to contain them posed an important risk to the expansion.

Some increase in inflation pressure was inevitable with the economy growing faster than its "potential" - the rate of growth it can sustain at full employment without generating inflation pressures.

"We estimate that over the last two years potential output has grown by a little over 2 per cent annually, compared with average GDP growth of 2.7 per cent. This gap between the actual growth rate and the potential growth rate increases pricing pressures in the economy," he said.

Factors constraining the recovery in potential output growth are that skilled labour is becoming hard to find and investment as a share of gross domestic product has only recently returned to its pre-recession levels, while multi-factor productivity fell during the recession and has been slow to recover.

Meanwhile, the demand side is benefiting from the Canterbury rebuild, housing shortages in Auckland, a rapid increase in net immigration, strong export commodity prices boosting farm incomes, rising house prices and low real interest rates.

Wheeler said the bank expected GDP growth to continue around an annual pace of 3.5 per cent over the coming year.

The interest rate projections in the bank's December monetary policy statement indicated the official cash rate would rise about 2 percentage points over the next two years. That would take it to 4.5 per cent, about the level the bank considers neutral - neither a tailwind nor a headwind.

But Wheeler cautioned yesterday that the timing and magnitude of increases in the OCR involved difficult judgments because changes in interest rates tend to affect output and inflation with a 12- to 18-month time lag, although it could be more rapid if the main transmission effects operated through the exchange rate. The bank's forecasts and projections have to be constantly reassessed in light of new data.

"In the past six weeks, for example, indicators on New Zealand's economic growth and inflation have been stronger than those built into our December projections, but the exchange rate has also been stronger and initial indications are that house price inflation may be starting to moderate, although it is too soon to draw firm conclusions," he said. "The exchange rate remains a considerable headwind for the economy, and the bank does not believe its current level is sustainable in the long run."

If actual inflation and inflation expectations were to rise significantly, competitiveness and real income growth would decline, Wheeler said, and the bank's subsequent efforts to maintain price stability by raising short-term interest rates would be more disruptive the further inflation was allowed to deviate from target.

The Reserve Bank's goal is to keep future average inflation near the 2 per cent mid-point of its target band.

"Achieving this will help to ensure that economic activity is kept more in line with the potential growth of the economy, thereby promoting a more sustainable growth path."