Brash leaves rates to address flat economy

By BRIAN FALLOW

Reserve Bank Governor Dr Don Brash has given the economy the benefit of the doubt and left interest rates unchanged.

But there is a lot of doubt. In particular the bank is wrestling with what to make of the sharp drop in business confidence mid-year, and the vexed issue of how much stimulation the whole economy will get from the very weak exchange rate.

"Given the uncertainty about the outlook, leaving the official cash rate unchanged [at 6.5 per cent] seems the prudent thing to do right now," Dr Brash said.

As expected the bank in its monetary policy statement has revised its inflation forecasts upwards, sees less growth this year but more next year and the year after, and projects a little upside in interest rates but less than it did three months ago.

It has 90-day wholesale interest rates, the driver of floating mortgage rates, rising from 6.7 per cent now to 7.2 per cent by 2002, while the exchange rate is expected to appreciate some 12 per cent over the next two years.

This central projection is based on business confidence recovering fairly quickly under the benign influence of strong growth among New Zealand's trading partners and a stimulatory exchange rate.

But it does not expect the resultant upsurge in business investment to occur until the second half of its three-year projection period.

Dr Brash said the most recent National Bank survey showed signs that the recovery in business sentiment had begun.

A range of factors had contributed to the drop in confidence, including concerns about Government policy and fears about how high interest rates might go, but their relative importance was impossible to tell, he said.

The bank's central projections also assume the coming "blip" to near 3 per cent in the consumer price index will not trigger a material secondary round of wage and price increases of the kind Dr Brash warned against two weeks ago which he would need to counteract through higher interest rates.

National Bank chief economist Brendan O'Donovan agrees that given the weak state of domestic demand there was little risk of second-round inflation at this stage.

"Employees are not in a position to demand wage increases out of line with productivity," he said.

But Deutsche Bank chief economist Ulf Schoefisch is less sanguine. He thinks the effect the weak dollar will have will be to keep inflation above 2.5 per cent for longer than the Reserve Bank thinks or is prepared to admit and that will increase the second-round effects.

The Reserve Bank is also taking a wait-and-see attitude to the question of how stimulatory the weak exchange rate is to exports in the first instance and then to domestic activity.

"At present we do not see a uniformly strong export growth profile across the board, nor do we have a strong sense of imminent spillover from export demand to more generalised domestic demand," the monetary policy statement said.

While the low dollar in the early 1990s triggered a very strong upswing, structural changes to the economy, and especially the manufacturing sector, since then could make the effect more muted this time round.