How fast and how far interest rates rise will depend in part on the exchange rate, says the Reserve Bank.

As expected governor Graeme Wheeler raised the official cash rate from 2.75 to 3 per cent yesterday and reiterated his intention to keep raising interest rates to the level at which they no longer add to demand in the economy.

But to the guidance paragraph in last month's statement that said, "The speed and extent to which the OCR will be raised will depend on economic data and our continuing assessment of emerging inflation pressures", he added this time, "including the extent to which the high exchange rate leads to lower inflationary pressures".

It is a reminder that to the extent there is causal connection between interest rates and the exchange rate, it works both ways. The bank repeated its belief that the current level of the exchange rate is not sustainable, dropping the qualification "in the long run".


The kiwi dollar and commodity prices have parted company, with the exchange rate rising to around 2 per cent above where the bank expected it would be now, despite auction prices for dairy products having fallen by 20 per cent in recent months.

Bank of New Zealand head of research Stephen Toplis said the dilemma the Reserve Bank faced was that it - and the country for that matter - would be better served with a lower currency and higher interest rates than presently the case.

"Engineering this outcome is near impossible. Instead, the bank is reliant on international markets deciding that the New Zealand dollar should fall. The bank continues to do its best in highlighting that this should be so but has no power to do anything else but talk about it."

The BNZ also believed the New Zealand dollar should soon start to fall and that the catalyst should be the recognition that declining dairy auction prices will eventually feed into the terms of trade, Toplis said.

"The terms of trade decline will happen at the same time that US tightening talk increases, New Zealand's GDP growth peaks and election uncertainty rises," he said.

"But ... we could end up in this really difficult position where the leading indicators tell us commodity price are falling but actual data show an improving terms of trade for the next couple of quarters.

"The longer the currency stays higher, the greater the chance there is a pause in the tightening process."

Market pricing implies an 85 per cent chance of another rise in the OCR in June and a cumulative 34 basis points of hikes over June and July.

Westpac chief economist Dominick Stephens said the Reserve Bank had signalled in March 200 basis points (2 percentage points) of tightening over two years. Because of the exchange rate it probably now thought 175 basis points would be necessary.

ANZ chief economist Cameron Bagrie expects another 50 basis points of OCR rises before the end of the year, with the next instalment in June.

As always the exact speed of the tightening would depend on emerging data and inflation pressures.

He said hotspots of non-tradeable inflation, notably construction, were going head-to-head with the high dollar.