Bank to be all bark, no bite, on cash rate

The inflation watchdogs at the Reserve Bank are expected to growl but not bite when they review the official cash rate on Thursday.

Market economists are unanimous that the bank will leave the OCR on hold at 6.75 per cent not only this time but for the rest of the year. Nine out of 14 in the latest Reuters poll expect the central bank to start cutting rates in the first quarter of 2006.

Economic growth has clearly passed its peak and has been running at a below-average pace since the middle of last year.

Deutsche Bank economist Darren Gibbs said there was a belief in the market, especially among overseas investors, that the economy was cooling rapidly and that this would deliver the reduction in excess demand and inflation that the Reserve Bank was looking for.

Westpac chief economist Brendan O'Donovan said it was evident that the main cause of slower economic growth was reduced demand rather than an inability to supply.

"The difference is crucial as it means that as growth slows inflation pressures will decline hand in hand."

Gauges of capacity constraints, such as what firms report about the difficultly of finding labour and how close they are to running their physical plant flat out, have eased back but remain at high levels.

Business and consumer confidence have fallen. Retail spending fell in May. Building permits for new dwellings issued in April and May were at historically low levels.

But economists point to several reasons why the Reserve Bank will still talk tough. Inflation at 2.8 per cent is uncomfortably close to the top of its 1 to 3 per cent target band.

Inflation in the non-tradeable or domestic sectors, unaffected by world prices and the exchange rate, was 1.1 per cent in the June quarter and 4.4 for per cent for the year.

Only subdued inflation on the tradeables side has kept the overall consumers price index in bounds. But in recent weeks the exchange rate has fallen sharply, making imports more expensive, while crude oil prices hover around US$60 a barrel.

Inflation threatens to breach the top of the Reserve Bank's target in the second half of this year and, although it is too late for the bank to do anything to prevent that, it will be worried about the impact it might have on inflation expectations.

"The bank can't afford to have the market jump the gun and drive interest rates and the exchange rate down any further," O'Donovan said.

"That was the lesson learned after last October's 'All done' statement, which prompted wholesale interest rates to drop and contributed to the year-end mortgage rate war."

Gibbs said that even though retail sales in May were down on April they were still up nearly 7 per cent on May last year.

"Developments in wealth indicators suggest that consumer spending will remain very firm. According to Quotable Value New Zealand house prices rose an eye-popping 5.2 per cent in the three months to June.

"And after falling sharply between March and early May the stock market has stormed back to record a new cyclical high."

Meanwhile the pressure for an easing in fiscal policy seemed to be building, Gibbs said.

Key ingredients

* Markets expect the Reserve Bank to leave interest rates on hold

* Inflation gauges are still in the danger zone

* More tough talking is on the cards