Interest rates on hold for the year

Alan Bollard

The Reserve Bank left the official cash rate (OCR) unchanged at 7.25 per cent as expected today, and offered little hope for interest rate relief this year.

In his latest quarterly review of monetary conditions, Reserve Bank Governor Alan Bollard said "we do not expect to be in a position to ease policy this year".

The decision is likely to mean that mortgage rates remain at about their current level throughout the year.

He repeated his assessment made in January that he did not expect to raise rates again in this cycle because of the slowing economy but said "realistic wage and price-setting behaviour", and the behaviour of the housing market, would determine when he finally relented on the interest rate front.

Inflation was expected to breach the bank's 1-3 per cent target in the current quarter and remain around 2.5 per cent during the next three years.

Straight after the announcement the New Zealand dollar spiked 20 points to US65.25c but within minutes it had started to calm down and by 9.30am was back at US65.09c.

Goldman Sachs JB Were economist Shamubeel Eaqub said the Reserve Bank had stayed on message.

"The most important part is that they don't expect easing this year. I think this was in direct relation to the early easing priced in by some in the market," he said.

Mr Eaqub said he still thought the economy would have slowed enough by September to allow rate cuts this year.

First NZ Capital economist Jason Wong was also still of the view that rates could ease around September or October.

At 7.25 per cent, the OCR is the highest key interest rate in the developed world, and compares to interest rates of 5.5 per cent in Australia, 2.5 per cent in the euro zone and 4.5 per cent in the United States.

Although Dr Bollard said recent data confirmed the economy had been slowing, household spending had only recently started to wane.

"A key driver of strong household spending has been the buoyant housing market which, while showing signs of cooling, still remains very active."

The bank predicts house price inflation will not only fall sharply but house prices will fall in absolute terms. However, the bank argues house prices will still be historically high relative to incomes.

Dr Bollard said he was conscious of the risk that holding rates up for too long could push the economy into a "hard landing" but he was grappling with inflation above the 1-3 per cent target and rising inflation expectations.

Inflation is expected to peak at 3.3 per cent this quarter but remain around 2.5 per cent during the next three years.

Wage demands

His warnings today seemed particularly aimed at workers' wage demands.

"Labour market and resource pressures have built up over many years of high growth and will take some time to dissipate," he said.

"Labour costs in particular are growing strongly, at a time when firms are finding it difficult to lift sales and productivity."

"Realistic wage and price setting behaviour" and reduced pressure from the housing market would be needed before interest rates could be cut, he said.

"As long as these inflation risks remain under control, we do not expect to raise interest rates again in this cycle," Dr Bollard said.

The bank is expecting growth to remain subdued while a major re-balancing in the economy took place, with a recovery in net exports and a weakening in domestic demand.

The bank lowered its forecast for growth from December with growth in the March 2006 year of 2.5 per cent predicted to slow to 1.5 per cent by 2007.

"A decline in the New Zealand dollar exchange rate is expected to play a role in this re-balancing," Dr Bollard said.

New Zealand's massive current account deficit, is predicted to peak at 9.25 per cent of GDP next year although it will remain above 6 per cent through the three-year forecast period.

Dr Bollard said hopes for an easing before this year required "a more rapid reduction in domestic inflation pressures than the substantial slowing already assumed in our projections".

- NZPA