Bollard tipped to tighten rates

By BRIAN FALLOW economics editor

Market economists are confident that Reserve Bank Governor Alan Bollard will tighten interest rates a quarter-turn on Thursday, raising the official cash rate from 5.5 to 5.75 per cent.

Analysts also expect the tone of the accompanying monetary policy statement to be on the hawkish side, foreshadowing a further tightening later in the year.

The financial markets are "pricing in" another rate hike by the end of the year.

At the last monetary policy statement in March Bollard left interest rates on hold.

At that stage the bank was forecasting economic growth to slow to around 1.75 per cent by March 2006, while the high New Zealand dollar provided an offset to the domestic inflation pressures which had built over two or three years of strong growth.

Since then, however, the economy has proven more resilient than expected and the exchange rate has dropped some 6 per cent from the level the bank's previous forecasts assumed.

That prompted Bollard to raise rates in April.

Among the indicators that the economy gained its second wind in the March quarter, keeping pressure on its resources, are:

* Employment grew 3.2 per cent in the year ended March, more than the bank had expected and enough to push unemployment down to 4.3 per cent.

* Retail sales rose 2.6 per cent in real terms in the March quarter.

* The construction sector continued to hum, up 14 per cent on the March quarter last year even after inflation.

The outlook has improved too, especially for the export sector.

World growth forecasts have been revised upward since March. Export commodity prices are at record highs, and the exchange rate has fallen.

But one of the harder judgment calls the Reserve Bank will have to make is whether it expects the kiwi dollar's decline to stick.

Bank of New Zealand chief economist Tony Alexander said the BNZ's view was that the dollar's level in recent weeks was probably at the lower end of the range it would trade at over the rest of the year.

Deutsche Bank chief economist Ulf Schoefisch expects the kiwi dollar to remain around current levels over coming months but then to climb back to 71USc by the middle of next year, as world currency markets become less impressed by evidence of economic recovery in the United States and more concerned by the size of its external deficit.

The US current account deficit nudged 5 per cent of GDP last year and Deutsche Bank analysis shows it could reach an insupportable 8 per cent of GDP over the next five years unless the US dollar depreciates.

In addition, Asian central banks, which have to a large extent funded the US deficit, have recently been adjusting the mix of currencies they hold, reducing the weighting of US dollars.

Other clouds on the international horizon are a downturn in Australia (led by a correction in the housing market), moves by Chinese authorities to rein in growth from the breakneck pace it has shown lately, and the soaring price of oil.

Westpac chief economist Brendan O'Donovan expects the Reserve Bank's inflation forecasts will show inflation above 2.5 per cent for the rest of this year, reflecting higher oil prices and the fall in the dollar.

Its medium-term projections are also likely to be bumping the 3 per cent ceiling of its inflation target.

"We agree with the short-term outlook for higher inflation, but it should be ignored for policymaking proposes.

"We disagree that medium-term inflation is such a threat."