'Scope for cash rate cut' says Bollard

By BRIAN FALLOW economics editor

The Reserve Bank's indicator light is flashing, signalling that it expects the next turn to be towards lower interest rates.

Governor Alan Bollard, as universally expected, left the official cash rate (OCR) unchanged at 5.75 per cent yesterday.

But he made it clear that he had abandoned his neutral stance in November and adopted an easing bias, and that the reason was the sharp rise in the New Zealand dollar since then.

"If sustained we expect the higher exchange rate to dampen future economic activity and hence medium-term inflation pressures."

On the other hand the domestic economy is looking stronger than the bank had expected and domestic inflation pressures continue.

"If the exchange rate remains at around current levels or appreciates further, and if the evidence points to reduced pressures on resources and medium-term inflation, then there may be scope for a cut in the OCR later in the year," Bollard said.

The Bank of New Zealand's head of market economics, Stephen Toplis, said: "What we have here is a battle between the deflationary impact of the New Zealand dollar and the inflationary housing sector.

"What we don't know is which of the antagonists will win the battle. What we do know is that the pace of the dollar's appreciation gives it the upper edge at the moment."

The money market is betting that the currency's effects will prove the stronger factor. Interest rate markets rallied on Bollard's statement and the swap market is now fully pricing in a 25-basis-point cut by the end of April.

Economists are not so sure.

The New Zealand dollar has climbed 10c against the United States dollar since August, but over the past two days it has given up 1USc of that gain. Is that a consolidation, a profit-taking pause in a continued uptrend, or the start of a more fundamental reassessment?

Time will tell, but Bollard's statement noted the need for the currency's gains to be sustained if they were to have the dampening effects that would warrant an offsetting interest rate cut.

In any case, ANZ chief economist David Drage said, even at its recent highs around 55USc the dollar was still close to its long-term average level.

"Even if we use the recent highs in key [exchange] rates to convert world prices, New Zealand dollar commodity prices would still be at the top of the range prevailing before in the 15 years prior to the exceptional period 2000 to 2002."

Recent gains against the Australian dollar overstate the relative strength of the New Zealand economy compared with the Australian one and some falling back is likely, Drage believes.

Deutsche Bank chief economist Ulf Schoefisch said that the dollar's appreciation had started from a very undervalued position, so its effect on export growth might not be as strong as if it had started to appreciate from a level where exporters' profit margins were already tight.

Drage and Schoefisch both point to the risk that the direct effect of the higher dollar on prices of imported goods may take a long time to flow through to consumers, demand being strong enough for distributors and retailers to get away with pocketing the gains in the form of better profit margins.

Bollard's other condition for a rate cut, evidence of domestic inflation pressures abating, may also take some time to emerge.

Last week's inflation data showed inflation in the domestic, non-tradables sector running hot at 3.9 per cent, compared with 1.8 per cent in the dollar-sensitive tradables sector.

The Institute of Economic Research's quarterly survey of business opinion reflected an economy at full stretch, with capacity use and skilled labour shortages at historically high levels.

Housing market activity meanwhile remains robust.

The Real Estate Institute reported the number of houses sold last month was 26 per cent up on December 2001 and 68 per cent up on the December before that.

On a nationwide basis house price inflation remains moderate, however, with the national median price up 8 per cent over the past year and 13 per cent over the past two years.

The expected decline in net immigration, which has been underpinning the property market, has yet to eventuate, perhaps because of a backlog in the system.