'Hawkish' Brash hints the only way is up

By BRIAN FALLOW economics editor

Reserve Bank Governor Don Brash has reinforced market expectations that the next move in interest rates will be upward.

His decision yesterday to leave the official cash rate on hold at 5.75 per cent was widely expected.

If there was a surprise in the monetary policy statement it was in what most - though not all - market economists took to be its hawkish tone.

"The current situation would point to an early increase in the official cash rate were it not for the risk that the international environment will turn out to be weaker than [the bank's forecasts] have assumed," Dr Brash said.

The bank expects inflation to drop from 3.2 per cent now to 2 per cent by the end of the year. It sees little or no spare capacity in the economy and believes that interest rates are broadly neutral, neither stimulating nor constraining demand.

But it dwells on the risks that its benign inflation outlook may prove optimistic.

One is the risk that further one-off price shocks such as the present electricity crisis will push up the inflation expectations which underpin the behaviour that sets wages and prices.

WestpacTrust chief economist Adrian Orr is bemused by such concerns, noting that surveyed inflation expectations are trending down.

The Reserve Bank's forecasts assume a sharp fall in export commodity prices, of the order of 7 per cent in New Zealand dollar terms, which would have a disinflationary effect. But it has been expecting such a fall for months and has been surprised by the continuing strength in export prices.

Dr Brash told MPs on the finance and expenditure committee that such a fall would "not be calamitous" for the economy and would be mitigated by the fact that some Dairy Board hedging at higher than present exchange rates had yet to roll off, implying next season's payout to dairy farmers may be significantly higher than for the past season.

The bank is projecting a "mild" increase in 90-day interest rates to 6 per cent next year and 6.25 per cent in 2003. The dollar is projected to appreciate 8 per cent over the next two years.

"The main factor that has spooked the bank," said BNZ economist Stephen Toplis, "is concern that the economy's capacity to expand is declining."

It has revised down its estimate of the potential growth rate, at least for the next two years, to 2.5 per cent from 3 per cent in the May statement.

If actual growth exceeds potential for any length of time, inflationary overheating is likely, so the bank's estimate of the potential growth rate is a crucial part of its monetary policy calculations.

The bank still believes the long-term potential growth rate is between 2.75 and 3 per cent but that at the present stage of the cycle growth in the workforce and in productivity are both below par.

Deutsche Bank chief economist Ulf Schoefisch said that while the market had taken the monetary policy statement to be relatively hawkish, he believed the Reserve Bank had retained an easing bias for the near term. He did not believe that the bank would in fact cut rates.