Reserve Bank expects strong dollar

Alan Bollard has held the official cash rate at 2.5 per cent. Photo / Mark Mitchell

The Reserve Bank sees stronger growth but less inflation over the year ahead than it did three months ago, and a higher dollar but lower interest rates.

While governor Alan Bollard, to no one's surprise, left the official cash rate unchanged at the all-time low of 2.5 per cent, the bank has lowered its projected track for short-term interest rates, with the first hike now signalled for this year's December quarter and only two more over the next two years.

The flipside is a kiwi staying high for the rest of the the year and then drifting lower only slowly.

The bank sees the dollar's recent strength as the unfortunate side-effect of an otherwise welcome development: markets' receding concerns about the risks of a financial crisis in Europe.

But yesterday Bollard reflected on the "unusual combination of monetary stimulus" from all the major central banks lately, with the Federal Reserve, the European Central Bank, the People's Bank of China, the Bank of Japan and the Bank of England all in their different ways easing monetary policy.

"When that all happens we do worry about the potential for competitive monetary stimulus.

"It certainly would be a disappointment if we got this far through the global financial crisis without an outbreak of competitive trade barriers ... only to run into competitive monetary stimulus."

Although the the bank sees the kiwi as overvalued, "we do see that as being driven primarily from international pressures rather than New Zealand pressures and in that sense it is limited what New Zealand can hope to do about it.

"Were we to see the New Zealand dollar strengthen to the point where it was bringing down our future expectations of inflation we always still have the prospect of reducing the official cash rate."

But although the high dollar hurts the tradeables sector - especially tourism and firms competing with imports - it lessens inflationary pressures.

The annual inflation rate has dropped below the mid-point of the bank's 1 to 3 per cent target range, inflation expectations have fallen sharply too, and downward revisions to the historical track for gross domestic product imply more spare capacity in the economy than had been thought - which has left the inflation in a "sweet spot".

But Westpac chief economist Dominick Stephens, while agreeing with the Reserve Bank on the outlook for growth and the exchange rate, believes it is too sanguine about inflation, when the construction sector faces the rebuilding of Christchurch, with a backlog of leaky homes and pent-up demand in Auckland after a slump in residential building.

"It has echoes of 2003," said Stephens. "In the face of clear evidence the domestic economy was accelerating, the Reserve Bank held back on hiking the OCR for fear of stoking what was already considered an overvalued exchange rate. In the end, rising house prices and a construction boom fuelled domestic inflation and the OCR ended up going much higher."