KEY POINTS:
Whether interest rates rise in the new year will mainly depend on the housing market, Reserve Bank Governor Alan Bollard says.
He left the official cash rate on hold at 7.25 per cent yesterday. But he warned that medium-term inflation risks had increased since the bank's September monetary policy statement, and there was a higher risk of a further rise in interest rates.
Bank of New Zealand economist Stephen Toplis said Bollard had not tightened because he was "petrified" that it might further boost the New Zealand dollar. Had he wanted to hike, the bank's forecasts gave him plenty of justification.
After a short-term drop, courtesy of lower oil prices, inflation is expected to climb back to the top quarter of the bank's 1 to 3 per cent target band and stay there, leaving little headroom.
And even that depends on projections of higher interest rates and a stronger dollar than the bank was expecting three months ago.
Household spending showed surprising resilience, the bank said. The labour market remained firm and the housing market appeared to have developed new momentum after slowing in the first half of the year.
Assistant Governor Grant Spencer said at this stage it was hard to tell whether that was a temporary blip or a housing third wind.
Household confidence had been boosted by the drop in petrol prices. Migration was also stronger than the bank expected.
"We think house prices are overvalued and getting out of line with fundamentals," Spencer said.
Bollard said it was salutary to look at what had happened to housing markets in Australia (the east coast) and more recently the US, where prices had come off substantially.
In New Zealand the bank is expecting a later and shallower decline in house price inflation than in previous forecasts - "although we still except a declining rate of growth followed by a a long period of weakness in house prices, especially in real (inflation- adjusted) terms".
The statement also gave a new prominence to the inflation risk from a more stimulatory fiscal policy, which is the net effect of how much the Government takes out of the economy in tax and puts back in spending.
"It is one thing if it were to happen at a time when the economy was softening. But actually this economy looks like it has gone through a soft landing and is picking up and becoming stronger again. We expect anyone involved in the fiscal side of Government to take that into account," Bollard said.
"However, we observe high surpluses and we know there will be pressure over the next couple of years, and what we are seeing this time is an economy with still quite significant inflation pressures, so there is less chance of fiscal expansion happening at a time when when the economy could readily absorb it."
SLOW GROWTH
* Growth troughed in calendar 2005 but will be stuck around a below-par 2.5 per cent a year for the next three years.
* Inflation drops to 2 per cent by mid-2007 but climbs to 2.7 per cent for the next two years.
* And that is with higher interest rates than now.
* And a slower decline in the exchange rate than expected three months ago.
* Unemployment rises but stays under 5 per cent.
