Rates move waits for households to feel the pinch

No one expects the Reserve Bank to adjust interest rates when it hands down its quarterly judgment on the economy on Thursday.

The focus instead will be on whether it is more worried by the short-term risks to inflation or the medium-term risks to economic growth.

A key judgment the bank's forecasters have to make is how much and how soon the pressure businesses are under will be transmitted to the household sector. So far in this downturn, the housing and labour markets have proven resilient - the labour market remarkably so.

While business profits are squeezed by higher energy costs, rising wage bills and a trend decline in the exchange rate which makes imported inputs and capital goods more costly, households have been shielded by lower unemployment, higher wages and the comfort of continued double-digit rises in house prices.

In its July review of the official cash rate, the bank said a sustained period of adjustment in domestic spending was necessary and it would be some time before an easing from the current 7.25 per cent could be considered. It would need to be confident that inflation was heading comfortably back below 3 per cent.

First New Zealand Capital economist Jason Wong sees no good reason for the bank to change its tune on that.

But he reads the recent economic data as generally running in the bank's favour.

The recent fall in petrol prices in particular reduced the risk that headline inflation would persist around 4 per cent.

The Bank of New Zealand's economists, who have long been at the hawkish end of the spectrum, now believe the peak in inflation is behind us.

Head of research Stephen Toplis said a big cutback in investment by corporate New Zealand was due.

He expected the Reserve Bank to start cutting its official cash rate in June next year. Anticipating that, short-term wholesale interest rates will fall substantially over the next 12 months, and deprived of the crutch of high interest rates, the kiwi dollar will tumble.

But even if the Reserve Bank reads the outlook the same way, it may be reluctant to say so, for fear of triggering a premature easing in monetary conditions when consumer price inflation is 4 per cent, inflation expectations are rising and wage inflation is showing only tentative signs of having peaked.

In recent weeks petrol prices have dropped, but during the three months since the Reserve Bank's last monetary policy statement, oil prices have been substantially higher than its forecasts assumed, and they still are, meaning more inflation pressure in the short-term but weaker growth and less inflation pressure in the medium-term.

The exchange rate has also been higher, about 4 per cent on average, than the bank expected.

Together with signs of softening in world economic growth, and a mounting risk of an El Nino event hitting agriculture, the firmer dollar retards the prospects of the export-led recovery the bank is looking for.

The financial markets have not entirely discounted the possibility of one more official interest rate hike; current pricing puts the changes at one in three.

But the prevailing view is that the next move in interest rates will be down, though probably not until the middle of next year.