Hawkish Bollard signals next move is up

By BRIAN FALLOW economics editor

Reserve Bank Governor Alan Bollard's hand is hovering near his holster after he yesterday endorsed financial markets' expectations of an interest rate rise in the first quarter of next year.

As expected he left the official cash rate unchanged at 5 per cent but the tone of the accompanying statement was hawkish, clearly signalling a shift from September's neutral policy stance to a tightening bias.

Bollard said strong inflation pressures were evident in some industries although those pressures had been largely offset by weaker imported inflation.

But the bank had limited headroom to absorb additional inflation pressures over the medium term. Current market expectations of interest rates, as reflected in financial market pricing, appeared broadly consistent with that view, he said.

That statement declares a winner in the argument between economists and money market dealers about the outlook for interest rates.

The markets have been pricing in an 80 per cent chance that Bollard will start to raise rates in January or certainly by the end of March. They see the OCR at 5.75 per cent by July, three-quarters of a percentage point higher than now.

The weight of opinion among economists has been that it would be the September quarter before Bollard needed to move.

Westpac chief economist Brendan O'Donovan thinks yesterday's statement was more hawkish than it needed to be.

"He's got time on his side: inflation, apart from the housing market, is well under control and even in the housing sector the factors which have been driving the market higher are abating quickly."

Although he did not mention it yesterday, in his September monetary policy statement Bollard voiced concern about an overheated housing market and the risk that it could spill over into more generalised inflation. The combination of higher housing costs and a tight labour market poses a risk of a pick-up in wage inflation.

The wealth effect meanwhile boosts consumption as people borrow and spend on the strength of paper gains in their net worth.

And he also worries about the longer-term effects of investment being diverted into housing from more productive areas.

O'Donovan said Westpac's model of the housing market, which takes accounts of such factors as population and income growth, interest rates, wealth effects and building costs, suggested that on average the market is overvalued by about 9 per cent. But the factors driving that were now turning, he said.

Fixed-term interest rates have already risen and floating rates look set to follow.

The inflow of migrants, while still strong, is easing. High levels of construction are adding to the supply of housing.

Other investment classes are beginning to post improved performances, while rental yields are low.

Meanwhile, O'Donovan said, the data did not show a problem of generalised inflation with measures such as the weighted median, at 0.5 per cent in latest quarter, bang in the middle of the bank's target range.

National Bank economist Cameron Bagrie said that while the risks to the export sector had eased, they had not been eliminated. "The New Zealand dollar has popped through the US60c level, a key psychological barrier."

On a trade-weighted basis the New Zealand dollar has been running lower than the Reserve Bank assumed in its September forecasts.

Its appreciation against the US dollar has been offset by weakening against the Australian dollar and the Japanese yen, which has taken over from the euro in bearing the brunt of a global rebalancing of currencies as the US dollar weakens under the weight of its current account and fiscal deficits. That means less downward pressure on inflation than the Reserve Bank was counting on.

But on a trade-weighted basis the NZ dollar has risen about 1 per cent this week. "The game's not over as far as currency appreciation is concerned," O'Donovan said.