Rebuff for Brash on rate increase

By BRIAN FALLOW

WELLINGTON - The Reserve Bank's increase in interest rates yesterday is unwarranted and, if intended to prop up the New Zealand dollar, counter-productive, says National Bank chief economist Brendan O'Donovan.

As expected, Governor Don Brash raised the official cash rate 50 basis points to 6.5 per cent, reflecting forecasts of robust economic growth and increasingly generalised inflation pressures.

One of the reasons the markets expected Dr Brash to raise rates was to match the 50-basis point rise announced by the United States Federal Reserve, lest interest rate differentials further weakened the New Zealand dollar, which was already at 14-year lows against the greenback on Tuesday.

If that was part of his motivation - and he would not confirm that yesterday - it was spectacularly unsuccessful.

The Kiwi continued to fall to a 15-year low of US46.4c, reflecting a lack of buyers and a perception that the momentum was downward.

"It is not interest rate differentials driving the exchange rate," Mr O'Donovan said, "it's the growth story. So when you raise interest rates it implies weaker growth going forward and is negative for the currency."


The Reserve Bank of Australia in its last two rate rises referred to currency weakness as a reason for moving and in both cases the exchange rate fell sharply afterwards.

"Last week [Reserve Bank of Australia governor Ian] Macfarlane indicated they would set policy with domestic considerations in mind and ignore Fed moves.

"We should have a similar approach here."

Mr O'Donovan believes the Reserve Bank is underestimating the extent to which the strong growth recorded in the second half of last year related to supply shocks, notably a bumper agricultural season and Y2K-related stock-building, rather than underlying increase in demand.

Having already raised interest rates 1.5 percentage points, and seeing retail sales flat and the housing market weak, it was unnecessary to pump more bullets into the domestic sectors of the economy.

Dr Brash was asked how he expected businesses to respond by investing if he made it more expensive to borrow.

He replied that even after yesterday's increase he did not see interest rates as restrictive, although they were no longer stimulatory.

He said the exchange rate was providing a strong stimulus.

The Reserve Bank expects that effect to wane as the currency undergoes a moderate appreciation over the next three years - 10 per cent from its present battered level.

But exporters will also benefit from robust growth in New Zealand's trading partners and the consequent strength of commodity prices.

The bank is bullish about the short-term growth outlook, despite the weakness of some indicators.

It is forecasting 4.6 per cent growth for the March 2001 year, then a slowdown to 2.7 per cent and 2.6 per cent in the next two years.

That is a more front-loaded growth profile than some private sector forecasters.

Reflecting it, the bank has a somewhat more aggressive forward track for rates than it did in March.

Ninety-day rates, now 6.8 per cent, are forecast to continue rising to 7.5 per cent in the first half of next year and to stay there for a couple of years.

"We have to wait and see how things evolve," Dr Brash said. "If the run of indicators tends to suggest the economy is slowing down more than we expect then clearly we have to proceed more gingerly.

"Conversely, if the economy begins to pick up again, which is what most commentators are expecting, then we proceed as outlined."

Deutsche Bank chief economist Ulf Schoefisch said the Reserve Bank's forecasts understated the core inflation risks from the labour market and import prices.

ANZ Bank chief economist Bernard Hodgetts believes the peak in 90-day interest rates will be 7.5 per cent, as the Reserve Bank predicts, but that it will be reached later this year.