Higher interest rates on hold

By BRIAN FALLOW

Business confidence remains weak, reinforcing expectations that the Reserve Bank will leave interest rates alone until March next year.

The National Bank's October survey showed that not only has pessimism increased, with pessimists outnumbering optimists three to one, but firms expect less activity and lower profits. Investment and hiring intentions are down. Export expectations have softened.

The only lines pointing up are expectations of higher inflation and interest rates, and more firms intending to raise prices.

In a similar vein, the Canterbury Manufacturers' Association's September survey found rising export sales were outweighed by weaker domestic turnover.

Investment intentions weakened compared with August. Hiring intentions had improved, but that was probably due to more respondents citing the lack of skilled staff as the largest constraint on growth.

National Bank chief economist Brendan O'Donovan said the Reserve Bank's job was becoming more difficult by the day, knowing the weak economy could not bear higher interest rates but fretting that increased import costs would lead to inflation expectations and higher prices. The survey found inflation expectations at the highest level in a decade.

The futures market is pricing in no change in the official cash rate before March and then a 25 basis point tightening between March and June.

Deutsche Bank economists believe the Reserve Bank will push up rates a further 100 basis points next year, but say that the market will continue to believe monetary policy is on hold until there is concrete evidence of "second round effects" - higher oil and other import prices feeding through to generalised and persistent inflation.

Mr O'Donovan attributed the prevailing gloom to continued weakness in the domestic economy, the currency plunging to record lows, net emigration, profits squeezed by rising costs, and heightened concerns about the international economy.

"In our view a soft landing is still the most likely outcome for the economy and we expect growth in our main trading partners to hold at 3.5 per cent," Mr O'Donovan said.

"The main reason is that, globally, core inflation is low, which gives central banks considerable freedom to cut interest rates if financial market turbulence threatens a hard landing."

If the international economy holds up, the National Bank expects New Zealand to get a second wind.

"We are forecasting GDP growth of 3.3 per cent this calendar year, followed by 3.5 per cent in 2001."

Meanwhile, ANZ Bank economists point to the weak currency as the harbinger of growth.

The Reserve Bank's Monetary Conditions Index, which reflects the currency and interest rates, has spent the past month below minus 1000, which is 500 points more stimulatory than it was in the early 1990s.

The MCI, however ill-fitted to its subsequent role in dictating monetary policy, was developed as a variable to indicate economic growth, not inflation.

Through the 1990s there was a good fit between the MCI, with a 12- to 18-month lag, and GDP growth.

If that relationship holds up, the present level of the MCI suggests growth should accelerate to 7 per cent by late next year, the ANZ Bank said.

However, it believes that scenario is unlikely.

"The current state of the economy has as much to do with weak sentiment and the impact of higher taxes and fuel costs on household incomes and business activity as it has to do with the prevailing level of interest and exchange rates."

It also suspects the MCI gives too much weight to the exchange rate.

"But that said, in 1998 there were few if any forecasters who would have believed GDP growth would be 5 per cent by the end of 1999."