Interest rate cut comes with warning

By BRIAN FALLOW economics editor

Reserve Bank Governor Alan Bollard delivered the expected interest rate cut yesterday - but fired a rhetorical warning shot at the housing market.

As was expected by most market economists, he cut the official cash rate to 5 per cent from 5.25 per cent.

The accompanying statement left the door open for "further reductions" - the plural may be significant - if export-sector activity continues to soften significantly.

Exporters have struggled with the combined effect of a sharp appreciation of the exchange rate over the past 18 months and feeble growth in the world economy.

Bollard's statement acknowledges that the dollar has retraced some of those gains in recent weeks but he, like many private-sector economists, is clearly unconvinced that this marks a turning point.

The exchange rate remained volatile, Bollard said, "and there is still potential for it to appreciate further in the months ahead".

Likewise, while the international economy had shown some brighter signs recently it remained fragile.

But Bollard's dilemma - the same one he has had since the start of the year - remains balancing the need to respond to the economic slowdown radiating from a suffering export sector against the risk that interest-rate cuts fuel inflation in the housing sector.

Last month, annual house-price inflation nationwide hit 14.1 per cent, and turnover was 30 per cent up on June last year.

Bollard said the strong housing market, boosted by rapid population growth, was in itself no bad thing but the bank had to be wary of its implications for consumer price inflation.

"We note that housing sector inflation is already quite strong and some investors have unrealistic expectations about this."

Although "unrealistic expectations' is mild language compared with Federal Reserve chairman Alan Greenspan's famous warning about "irrational exuberance" in the United States sharemarket at the height of the dot com boom, the underlying concern is similar - that an asset price bubble can do damage when it bursts.

Although house prices themselves are not in the consumers price index, in terms of which Bollard's inflation target is defined, rents and construction costs are.

He also has to be mindful of the wealth effect of higher house prices: if homeowners see the value of their property rise by, say, $20,000 they are liable to borrow and spend several hundred dollars on the strength of that, over and above any underlying growth in their incomes.

Bollard said that whether there was room for a further rate cut in September would depend on where the net effect of those two offsetting forces lay: relatively robust domestic activity and inflation versus the weaker activity and inflation being experienced by the tradeables sector.

The Westpac chief economist, Brendan O'Donovan, said monetary policy was entering the fine-tuning stage in which the risks to the inflation outlook were edging into balance.

"There seems to be a recovery under way internationally which will take some of the hurt out of the export sector, but the exchange rate is what we will be watching most closely."

If the market's attention returned to the extent of the US current account deficit and the need for a global rebalancing, the US dollar would weaken and the New Zealand dollar would rise on the back of that.

"Then we would have scope for further interest rate cuts," O'Donovan said. "We need a higher currency like another hole in the head but it could happen."

The kiwi dollar was probably about 10 per cent overvalued but in past cycles it had been over- or undervalued by as much as 20 per cent.

The New Zealand dollar rose yesterday as the market digested Bollard's statement, noting that the kiwi is likely to remain one of the highest yielding currencies even after a further cut to 4.75 per cent. After trading around 58.1USc before the statement, the kiwi had risen to 58.5USc by the close of local trade.

ASB Bank chief economist Anthony Byett said the mix of low interest rates and rising house prices was attracting speculative investor interest in the market. Some were buying on a yield (rent-to-price ratio) of less than 5 per cent. He expected the housing market to remain strong for some time yet.

"We probably will get a bubble and some people will get burned, but it won't be a major problem [in] three or four years ... Whereas if businesses shut and people lose their jobs in the export sector it has a more enduring impact."