Inflation a concern but banks make Bollard's job easier

While most of the Reserve Bank's statement on interest rates yesterday was cut-and-pasted from January's, an exception is that it no longer expects inflation to remain "comfortably" within its target range of 1 to 3 per cent over the medium term.

It expects the emissions trading scheme, which comes into effect for the energy and transport sectors on July 1, combined with unusually large ACC increases, to push inflation towards 3 per cent in the short term, from 2 per cent now.

Officials estimated last year that the ETS would lift retail electricity prices by 5 per cent and add 4c a litre to the cost of petrol and diesel.

The prospect of inflation nearing 3 per cent does not include the impact of the rise in GST the Government has foreshadowed, which Statistics NZ calculated would push up the consumers price index by another 2 per cent. It could come into effect as soon as October 1 but until it is formally adopted as Government policy the Reserve Bank will not incorporate it in its official inflation forecasts.

A spike in inflation towards 5 per cent is not necessarily a problem for Governor Alan Bollard, or for borrowers. In setting the official cash rate he is expected to ignore one-off impacts on inflation arising from changes in Government policy, except to the extent they raise longer-term inflation expectations and encourage people to seek to recover their higher costs from their customers or employers.

But while a near-term spike in inflation can be "looked through", some economists were troubled that the Reserve Bank's medium-term inflation projections remain in the top quarter of its target range.

"And that is after what the bank itself expects to be a sub-par recovery in economic growth," Westpac economist Michael Gordon said. "God forbid we have a normal recovery."

The bank's March statement sees the "relatively sluggish" economic recovery it predicted in previous statements continuing to play out. It is forecasting economic growth of just over 3 per cent this year, which means that it will not be until next September that the economy has fully recovered the ground lost since its peak in 2007 - three lost years.

The 4 per cent growth predicted for 2011 would still be modest compared with previous recoveries, it said.

But the quality of the recovery is looking better - so far - from the bank's point of view.

Last year it fretted about the risk of an unsustainable rebound based on a resurgent housing market and debt-fuelled consumption. Now it expects house prices to go sideways over the next three years, in real terms, and the pickup in consumption it forecasts - 2.8 per cent this year - is hardly rip-roaring.

On the external front, while half of New Zealand's trading partners, led by Australia, are looking good, the outlook for Western economies, especially Europe, remains weak. "We are still talking about a world recovery that is is fragile," Bollard said.

As expected, he left the official cash rate at 2.5 per cent and reiterated that he expected to start raising it "around the middle of 2010".

But the bank added that when it does go into tightening mode it might not have to raise the OCR as far, all else being equal, as it would have in the past. Its brakes, in short, have become less spongy.

Partly this is because there is a much wider wedge or risk margin than there was pre-crisis between the OCR and what the banks have to pay for funds and then recover from borrowers.

The Reserve Bank expects that to persist as increasingly debt-laden Governments compete for funds globally. It leaves the bank with less work to do through the OCR.

Monetary policy should also get more traction from the return to a positive yield curve - where long-term money costs more than short-term money - which has encouraged borrowers to go for floating or short-term fixed rate mortgages. That means there should not be the long lag there was during the last boom between what the Reserve Bank does and its impact in the mortgage belt.

But this does not mean that the rates borrowers pay will be lower, only that the OCR will not have to go so high.