Hawkish governor swoops

By BRIAN FALLOW economics editor

The Reserve Bank is in a heightened state of alert, watching for signs the surge in inflation it expects next year might become entrenched.

Releasing the bank's June monetary policy statement yesterday Governor Alan Bollard not only delivered the expected 25 basis point increase in the cash rate but warned that "further increases in interest rates look likely to be needed over the year ahead".

Inflation in the internal or non-tradeable sectors of the economy is already running at around 5 per cent. Until recently that was offset by a high exchange rate, which delivered falling prices in the tradeables sector.

The net effect has been to keep consumer price inflation - around 1.5 per cent for the past year - below the middle of the bank's target range.

But the kiwi dollar's retreat in recent months and the rise in international oil prices will see inflation rise rapidly to more than 3 per cent by early next year, the bank forecasts, and stay there for a year - no matter what it does now.

That is not a breach of the bank's riding instructions, the policy targets agreement, which only requires it to keep inflation within the 1 to 3 per cent band "on average over the medium term".

"However, we will need to remain alert to signs of more enduring effects that could arise if wage or price-setting behaviour starts to change," Bollard said.

The lift in inflation to levels beyond the bank's comfort zone comes at a time when the economy's resources, including labour, are stretched tight - perhaps the tightest they have been since the 1970s, Bollard said.

Although overall wage inflation so far has been quite subdued, "our business contacts suggest that firms have needed to pay increasingly higher wages to attract new staff, particularly for skilled workers".

The bank is foreshadowing at least two more turns of the monetary screws, projecting 90-day bank bill rates of 6.5 per cent by the first half of next year.

That is a more aggressive outlook than the markets had had. They had priced in one more rise of 25 basis points and about a 50:50 chance of one beyond that.

Economists' reaction was generally that the bank's latest forecast sees more inflation in the offing than will eventuate.

"They are obviously concerned about inflation expectations, which are edging up," said National Bank chief economist John McDermott.

"But identifying where inflation pressure is coming from and how long it is going to last is tricky. It's like diagnosing an illness. At first is is very hard to make the right diagnosis, but if you do it is easy to treat. If, however, you wait until the disease - in this case inflation expectations - is clearly identified it is often too late."

The second opinions from the markets do not back up the bank's diagnosis, he said.

Westpac chief economist Brendan O'Donovan said this year's rate hikes would be next year's cuts.

"They say there are compelling reasons to expect the economy to slow but then they ignore them," he said. "In particular we believe that once the crutch of the housing market is progressively taken away domestic inflation pressures will decline noticeably."

HSBC chief economist John Edwards said despite Bollard's warning of "further increases" the New Zealand economy would get lucky and one more would prove enough.

"We expect growth to slow a touch as a result of slower population growth, higher interest rates, the beginning of the end of the housing upswing and perhaps some discomfort from the marked appreciation of the New Zealand dollar over the Australian."