Bollard's rates call under scrutiny

Reserve Bank governor Alan Bollard. Photo / Mark Mitchell

Reserve Bank governor Alan Bollard is expected to leave the official cash rate on hold at 2.5 per cent on Thursday.

Instead the markets will be scrutinising the accompanying statement for clues about what risks worry him.

On the one hand is the risk that recovery will be stunted by premature tightening of monetary conditions, with the exchange rate high and the markets pricing in a return to rising interest rates sooner than Bollard's past statements would warrant.

That would imply a dovish tone to Thursday's statement, leaving the door open to further OCR cuts.

On the other hand he has been fretting, in last month's monetary policy statement and again in a speech on July 14, about the possibility households will return to the unsustainable borrow-and-spend behaviour of the recent past.

If that is front-of-mind, the bank's language is likely to be more stern than it has been for some time.

Since the last OCR review on June 11, prospects for the global economy have brightened.

For the first time this year economists polled by Consensus Forecasts this month expect the global economy to expand next year - although by less than they expect it to contract this year. Because nearly half New Zealand's trade is with emerging Asia and Australia, trading partner growth is expected to outperform the global average in both years.

"Already there are clear signs that commodity prices are up off their lows," Bank of New Zealand head of research Stephen Toplis said.

But the problem for New Zealand is that the biggest commodity exporter, the dairy industry, has been hit by the reinstatement of export subsidies by Europe and the United States.

In addition the exchange rate is 7.5 per cent higher on a trade-weighted basis than the Reserve Bank assumed it would be over the second half of this year when it drew up its forecasts last month, calling into question its assumption the currency will continue to fall over the next 18 months.

ASB chief economist Nick Tuffley regards this as wishful thinking.

"New Zealand does have weak fundamentals and some clear external vulnerabilities, which are a risk to the New Zealand dollar but not the dominant driver," he said.

"Rather, relative performance appears to be having more influence. So far New Zealand has weathered the recession better than most."

Eventually the Reserve Bank may need to deliver further OCR cuts, to mitigate the impact of the higher dollar and rein in market expectations on the interest rate outlook, Tuffley said.

The financial markets are pricing in three, or more likely four, 25-point increases in the OCR by this time next year, according to Credit Suisse's swaps-based indicator, despite Bollard's "expectation" that he will keep the OCR at or below 2.5 per cent until the latter part of next year.

But they see almost no chance that the OCR will be cut this week. Nor do market economists. Of the 16 forecasters polled by Reuters only two are calling a cut this week and the average expectation for the OCR in eight months' time is 2.45 per cent.

"Locally the data continues to point to a gradual recovery," said Westpac economist Michael Gordon.

"Consumer and business confidence have held their recent gains, retail spending has been a little stronger, house sales are running at a stronger pace than a year ago and [house] prices have stabilised. These factors have all been underpinned by low interest rates and stronger net inward migration."

But with the prospect of recovery comes a growing concern households could revert to their previous borrow and spend ways, Gordon said.

"Renewed house price inflation and falling savings rates would be a sure sign interest rates are too low," he said.

"We think Dr Bollard's speech was the first step in preparing the market for the unpleasant fact that one way or another ... through OCR hikes, greater use of prudential regulation, or market forces, interest rates are going to be higher in coming years."

KEY INDICATORS

* The Reserve Bank will leave the official cash rate unchanged.
* Economists are divided on whether it will leave the door open to further cuts.
* It will want to lean against a premature tightening through the dollar and wholesale interest rates.
* But it is wary of a return to the borrow-and-spend excesses of the recent past.