Bank barks but saves the bite for next year

By BRIAN FALLOW

Reserve Bank Governor Dr Don Brash barked but did not bite yesterday.

Financial markets were not surprised that Dr Brash left interest rates on hold, but the hawkish tone of the December monetary policy statement did surprise many.

"If everything evolves as we expect there will be a need for another 100 basis points [on interest rates] over the next year or so," said Dr Brash.

That is more of a tightening than most market economists have been forecasting and considerably more than the markets have priced into rates.

The possibility of the low confidence, weak growth scenario the bank was contemplating in its August statement has dissipated.

The spectre of stagflation conjured by Dr Brash in October has also vanished.

The bank sees growth heading towards an above-trend 3.5 per cent over the next couple of years, accompanied by falling unemployment (5 per cent by 2003) and an improvement in the current account deficit to 4.5 per cent of GDP.

The forecast spike in inflation is now higher - 3.8 per cent over the next couple of quarters, compared with the 2.9 per cent peak forecast three months ago.

But the bank expects that will have only a minimal effect on wage and price setting and will quickly subside - an assumption analysts variously described as surprising, optimistic and brave.

The Reserve Bank admits, in sketching an alternative to its central forecast, that there may be more of a spillover into widespread and persistent inflation, and that the response to the stimulus of a weak currency may be less muted than it expects.

In that case, a more vigorous monetary policy response would be required, pushing 90-day interest rates up about 2 percentage points over the next two years, from their present 6.7 per cent.

The bank says that the muted response to what is historically a very low exchange rate reflects several factors:

Uncertainty about how fast resources can be transferred from the domestic to the external sector.

Exporters remembering how high exchange rates went in the last cycle and being wary about committing themselves to investment plans, preferring to see if the present weakness persists.

Manufacturing exporters squeezed by dearer imports, priced in US dollars, while the exchange rate with Australia, their main market, has not moved much.

Risks surround two other key assumptions the bank is making.

One is that the exchange rate will appreciate only 6 per cent over the next two years.

A more vigorous appreciation could do part of the Reserve Bank's job for it, said Dr Brash. It is also factoring in a soft landing for the world economy, with growth in New Zealand's trading partners dropping back to its long-run average of about 3.5 per cent.

Deutsche Bank chief economist Ulf Schoefisch agrees.

"I fail to see why the world should go into a hard landing or recession. There is no fiscal crunch because deficits are getting out of control; there is no monetary policy crunch because inflation is getting out of control. Oil is tight but not to the extent it would lead to something like an Asian crisis scenario. The only thing that is really there is the [equity market] bubble bursting in the United States, and it has come down a long way already."

WestpacTrust chief economist Adrian Orr, on the other hand, suspects that by the time of the next monetary policy statement, in March, the global outlook will be a lot blacker than the Reserve Bank has factored into its projections.

"Is the bank really going to lift interest rates if the US economy looks to be heading for a hard landing?"

Dr Brash said: "We are not in the same stage of the cycle as the US. In principle we could be in a situation of increasing rates relative to the Federal Reserve's."

The New Zealand dollar, which had been trading around 42.2USc before the MPS was released, was sold down to 41.9c before recovering to 42.5c by late afternoon. Ninety-day bill yields rose 4 points, to 6.72 per cent.