Official cash rate expected to hold

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Despite continued weak inflation, the Reserve Bank is tipped to hold steady

The Reserve Bank is unlikely to cut its official cash rate, economists say, despite another quarter of weak inflation. The consumers price index fell 0.2 per cent in the December quarter, when the markets and the Reserve Bank had expected a 0.1 per cent rise.

It means the annual inflation rate at 0.9 per cent is below the bottom of the bank's 1 to 3 per cent target band for the second quarter in a row.

Measures of underlying inflation are also benign. Non-tradeable inflation, reflecting items where world prices and the exchange rate are not a factor, rose just 0.3 per cent.

Over the past year a shrinking proportion of the 710 items in the CPI basket have been rising in price and a growing number falling, to the point that as many fell as rose in the December quarter, and by more.

It is the sixth quarter in a row that inflation has come in below the Reserve Bank's forecast, a cumulative error of 1.9 percentage points.

"It will only add to concern that there is some systemic bias in the Reserve Bank's inflation forecasting process," Bank of New Zealand economist Doug Steel said.

The accuracy of its forecasts is important because the bank's target is framed in terms of keeping future inflation between 1 and 3 per cent on average over the medium term.

But Westpac economist Michael Gordon said the forecast errors had been mainly on the tradeable inflation side and in large part reflected a surprisingly strong exchange rate.

"The [dollar's] trade-weighted index is 11 per cent higher than they expected a year ago and as a result the inflation rate is about 1 per cent lower."

The CPI, which is not seasonally adjusted, has fallen in four of the past five December quarters (the exception being 2010 when the GST rate rose). Food prices, especially vegetables, were a major factor.

Excluding food, which makes up 19 per cent of the basket, the CPI would have risen 0.3 per cent in the quarter and 1.3 per cent over the year.

ASB economist Jane Turner said falling food prices over the past year were largely the result of a fall in dairy prices from high levels in late 2011.

But in the year ahead the effect of last year's United States drought on world prices for dairy products and meat would flow through to New Zealand supermarket shelves.

More broadly ASB expects the New Zealand dollar to stay high and keep tradeable inflation subdued.

"But on the non-tradeable side, as we see the broader economic recovery gaining traction, that will lead to wider price rises," Turner said.

Reserve Bank staff would be concerned about near-term weakness and remaining downside risks, she said. "But their projections will still be for rising inflation pressure from 2014 onwards and their focus is the medium term. The horizon in which they have the greatest influence on inflation is one year from now."

ASB now expects the first OCR hike to come in March next year.

"But one risk in waiting until then is the evident heating up in parts of the housing market and acceleration in credit growth.

"Both of these factors are likely to cause increasing concern for the Reserve Bank and earlier OCR increases are still possible."

ANZ economist Mark Smith said that were it not for the need to rebuild Christchurch and the "perkiness" of the housing market the case for a lower OCR would be solid.

However both represented risks to the medium-term inflation outlook that kept the odds tilted towards the next OCR move being up, not down, though "well down the track".