Warning extravagant wages could lead to interest rates rise

Dr Bollard said the economy was going through a phase of rebalancing. Picture / Mark Mitchell.

Reserve Bank Governor Allan Bollard has warned he might push up interest rates if workers get "extravagant" pay rises.

The Reserve Bank today left the Official Cash Rate at 7.25 per cent despite predicting inflation would nudge 4 per cent this year.

The cash rate sets the floating interest rate and heavily influences the cost of mortgages.

Dr Bollard told a select committee hearing after the release of the bank's monetary policy statement today he was able to keep a hold on interest rates despite the inflation outlook being more gloomy than in the past.

This was because oil prices were 20 per cent higher and the New Zealand dollar had fallen.

Both of those effects the Reserve Bank could "look through" as long as they did not flow on to wages, prices and inflationary expectations.

The Reserve Bank fears inflationary expectations because it leads to people and businesses expecting prices and wages to go up at higher rates than inflation creating yet more inflationary pressure.

"We would not expect to tighten monetary policy (push up interest rates) due to this short term hike in inflation," Dr Bollard said.

"But were we to see second round effects of this becoming entrenched in the system, for example, through more extravagant wage rounds or price setting activities by businesses or inflationary expectations picking up generally then we might have to stand against that to stop higher inflation getting entrenched into the economy."

This would mean the recovery in economic growth predicted to take place year would be delayed, he said.

The Reserve Bank uses the Labour Cost Index to measure wage increases. The index is currently growing at 3 per cent and the Reserve Bank predicts this trend to continue.

Wage and price growth in excess of this could see Dr Bollard consider increasing interest rates, though he said he did not expect to have to.

Dr Bollard was asked if New Zealand was entering a period of stagflation - ie a stagnant economy with no growth in demand or employment which still experienced inflation.

"I think we can sort of knock that on the head. New Zealand has been through a period of very, very strong growth. We are going through a period of rebalancing at the moment," Dr Bollard said.

This was desirable and there would be a "soft" economic land that "had nothing to do with stagflation".

- NZPA