Interest rate forecasts lowered

By BRIAN FALLOW

Analysts are revising their expectations of how much higher interest rates will go amid signs the growth outlook is weakening.

Reserve Bank Governor Don Brash yesterday left the official cash rate (OCR) unchanged at 6.5 per cent.

Dr Brash has raised rates two percentage points since he started tightening last November.

The futures market a month ago was pricing in a further 50-basis-point rise in 90-day bank bill yields, which drive floating mortgage rates, by the end of September.

All of that expected increase has now been taken out of futures prices, although the market is still pricing in a further 25 point rise by the end of December.

This reflects data, especially about the woeful state of business and consumer confidence, which suggests the short-term growth outlook is substantially weaker than the Reserve Bank forecast in May.

Deutsche Bank economist Darren Gibbs said: "The view among traders now is that unless we see a significant pick-up in confidence in the next five weeks, which seems unlikely, the bank might find it verydifficult to move in August, in which case maybe the focus becomes the next OCR review in October."

Economists have been slower to revise their expectations, though the trend is the same.

A Bridge News survey last Friday of 16 analysts found 10 expecting the Reserve Bank to raise rates - most by 25 points on August 16.

Four analysts think there will be no further tightening.

But even though the consensus among market economists is that Dr Brash will give the screw another quarter turn next month, raising the OCR to 6.75 per cent, it is increasingly seen as a close call.

Mr Gibbs said: "Our central call at the moment is that they will go 25 points because the inflation outlook is not promising over the next year."

It came down to how concerned the Reserve Bank would be about the "second round" impacts (through higher wage settlements) 12 to 24 months ahead if inflation tops 3 per cent by the end of the year, as Deutsche Bank forecasts.

"I think the Reserve Bank still fundamentally thinks the economy is strong and that if we can just get through this period of pessimism, beyond that the future looks bright, so that monetary policy needs to be tighter at some point."

Dr Brash would also be concerned that if he did not raise rates in August it might be seen as a signal they had already peaked.

Although Deutsche Bank still thinks the OCR will peak at 7.5 per cent by the middle of next year, implying a peak in floating mortgage rates of about 9.5 per cent, that is now a hawkish expectation.

Bank of New Zealand chief economist Tony Alexander is among those now forecasting a peak of 7 per cent in the cash rate by the middle of next year.

"And then things could be quite flat for a while because by then it is likely that export sector growth will be feeding through more to the domestic parts of the economy," he said.

Even though floating mortgage rates might go up another half a per cent, fixed rates might have already peaked for this cycle.