Bollard keeps rate at 2.5 per cent

Reserve Bank Governor Alan Bollard announcing last month's decision to keep the OCR at 2.5pc. Photo / Mark Mitchell

The Official Cash Rate

Reserve Bank Governor Alan Bollard held the official cash rate at 2.5 per cent, as expected, and said the strength of the New Zealand dollar may limit the need for future rate hikes in the short term once he removes the emergency cut imade n March.

Bollard said the economy has rebounded faster than anticipated, and the emergency rate cut in March, when the central bank sliced half a percentage point from the benchmark rate has "little need" to stay in place for much longer provided global risks recede and the local economy keeps recovering.

"The current very high value of the New Zealand dollar is acting as a drag on the New Zealand economy," Bollard said in a short statement. "If this persists, it is likely to reduce the need for further OCR increases in the short term."

A surging kiwi dollar has held back Bollard's favoured export-led recovery, topping a new post-float high 87.61 US cents in trading yesterday. That's kept a lid on foreign sales, with June trade data showed merchandise export receipts of $3.97 billion last month, more than $200 million less than expectations, for a monthly surplus of $230 million.

The strength in the currency has come from an improving domestic outlook and ongoing global weakness. Record high commodity prices, led by Asian demand for New Zealand's dairy products, have underpinned the local economic recovery and reinsurance money flowing helped stoked demand for the kiwi. At the same time, ongoing sovereign debt issues in the US and Europe have kept the greenback out of favour.

US debt is keeping global markets nervous, as partisan policymakers struggle to reach an agreement to lift America's US$14.3 trillion Federal government borrowing cap and avoid default and a credit rating downgrade.

Bollard said the uncertainty around the US government's debt ceiling and fragility in global financial markets, which has seen Greece get another bail-out from its European partners, highlights the downside risks to New Zealand's trading partner activity in the June monetary policy statement.

New Zealand's economy grew at twice the pace of market expectations in the first three months of the year, expanding 0.8 per cent, while inflation sped away to an annual pace of 5.3 per cent in the second quarter.

That's put pressure on Bollard to hike rates faster, and markets are betting he'll start lifting the OCR in September, having previously predicted December for the earliest increase.

Prior to the announcement, traders were betting Bollard will hike rates by 101 basis points in the next 12 months, according the Overnight Index Swap curve, and the two-year swap rate has increased about 25 basis points to around 3.65 per cent since the upbeat inflation and economic data.

Still, Bollard talked down the risk of inflation, saying the current spike was driven by the government's increase in consumption tax in October last year, when it lifted GST to 15 per cent.

"Wage and price setters should focus on underlying inflation, which is currently estimated to be below 2.5 per cent," he said.

The central bank's inflation target is a band of between 1 per cent and 3 per cent over a medium term horizon.

"The Reserve Bank is assuming that inflation expectations are simply reacting to the rate of headline inflation, and will come down when headline inflation falls later this year," Westpac Bank chief economist Dominick Stephens said in a note before the release. "We are sceptical, but the Reserve Bank's assumption won't really be tested until early next year."

Resilient business confidence is stoking inflationary pressures, with firms' pricing intentions and inflation expectations at elevated levels in this month's National Bank Business Outlook.

Companies have bounced back from the doldrums in March when the 6.3 magnitude earthquake in Christchurch killed 181 people and caused as much as $15 billion of damage.

See recent Reserve Bank changes to the Official Cash Rate here.