WELLINGTON - Whether New Zealand's short-term boomlet will be followed by an inflation-driven bust will largely depend on what happens to business investment this year.

That is the warning from Bank of New Zealand chief economist Tony Alexander in his latest monthly commentary.

Capacity constraints, which can lead to price rises, have emerged early in the current upturn and there is still no strong sign that businesses intend addressing these growing constraints, Mr Alexander said.

The unexpectedly rapid disappearance of spare capacity in the economy has been cited by the Reserve Bank as a reason for raising interest rates.

The BNZ has raised its forecast track for interest rates. It has 90-day bank bills sitting at 7.8 or 7.9 per cent for most of 2001, which would imply mortgage rates approaching 10 per cent.

The upward revision reflects fresh concerns about the extent balance of payments concerns will weaken or delay the expected cyclical rise in the exchange rate, the increased risk of higher interest rates in the US, "and most importantly of all, stronger concerns about capacity pressures pushing local inflation upward."

The Institute of Economic Research's most recent quarterly survey of business opinion (QSBO) reported a sharp jump in capacity utilisation among manufacturers and builders, to levels seen in the mid-1990s boom.

"This jump is in line with the strong anecdotal feedback we have been receiving of exporting manufacturers running into capacity constraints," Mr Alexander said.

In another survey, conducted by the Northern Employers and Manufacturers Association (EMA), 35 per cent of manufacturers said they were at full capacity.

But in the QSBO only 2 per cent of respondents said they intend to increase investment in plant and machinery over the next 12 months.

Nor can this reluctance to invest be put down to hard attitudes towards business investment by the banks. Only 5 per cent of firms in the QSBO cited finance as a source of constraint on growth, down from 7 per cent a year ago.

Capacity constraints are also beginning to bite in the labour market, Mr Alexander said. The unemployment rate is just 0.3 per cent above the low reached in the last economic cycle.

In the association's survey, 43 per cent of manufacturers reported difficulties in recruiting skilled staff.

While the rapidly tightening labour market was good for household income growth and retail sales, it would add to pressures on wages and costs in general, Mr Alexander said.

The reluctance to invest reflected the perception that some Government policies may raise business costs - such as the return to ACC and the repeal of the Employment Contracts Act.

"But we doubt it," Mr Alexander said. "The signs of strong economic growth have been clear for a long time now and one has to question just how capitalistically risk-taking New Zealand business people really are, if they place themselves in the current, deficient capacity position."

Some small signs of improved investment were beginning to emerge, Mr Alexander said.

"Hopefully these indications strengthen, because failure to invest now will result in a surge in inflation over 2001 and much more rapid rises in interest rates than would have to occur if businesses had a bit more faith themselves."