Posted on 29-1-2004

Unexpected hike in official cash rate

Reserve Bank Governor Alan Bollard surprisingly hiked the cash rate today in a move that is almost certain to send the kiwi dollar rocketing higher.

He justified the quarter of a percentage point increase in the Official Cash Rate (OCR) to 5.25 per cent as a move to check the booming domestic economy, particularly the housing market.

But it is likely to hurt exporters who are already in pain from the soaring currency.

"An increase in the OCR appears warranted to ensure that inflation remains comfortably within the (1-3 per cent) target range over the medium term," Dr Bollard said in a statement.

Inflation in 2003 was just 1.6 per cent and few economists expected a rate hike so soon, especially as the kiwi is restraining import prices.

Westpac New Zealand chief foreign exchange dealer Basil Payn said last night that the currency market had not factored in a rate rise and he predicted the market would aggressively buy the currency on a rate hike.

The kiwi dollar rose one US cent yesterday and was at US67.90c before the announcement. It is up 3 per cent this year and rose 25 per cent last year and 23 per cent in 2002.

New Zealand's economy is expected to slow this year while the United States economy is growing strongly, but minutes before Dr Bollard's move the US Federal Reserve decided to leave its rates unchanged at 1 per cent -- a 45-year low.

Dr Bollard said the New Zealand economy had experienced a period of impressive growth other the past two years.

"But now productive capacity and the labour market are becoming relatively tight.

"Reflecting this, inflation pressures in some parts of the domestic economy have started to become more apparent.

"Although falling import prices due to the rising exchange rate have so far kept CPI (consumer price index) inflation low, those reductions are unlikely to be sustained.

"If domestic inflation is left unchecked, the CPI may start to rise to uncomfortable levels," Dr Bollard said.

His move is almost certainly aimed at the housing market where prices rose on average more than 20 per cent last year.

Dr Bollard said that data since December had pointed to stronger activity than had been expected in areas such as household spending, construction, and the housing market.

That was fuelling inflation, he said.

Dr Bollard expects further inflation pressure in the next few months from higher construction costs and energy (power prices).

Interest rates had been stimulating demand as shown in the "further solid growth in household credit", he said.

The "prudent" move was to act now to move rates to less stimulatory levels and that could mean less aggressive rate moves later this year, he said.

"By raising rates now, we hope to avoid having to increase interest rates more aggressively later on."

Dr Bollard said he did not expect a large adjustment in rates would be necessary.

He said the bank was aware that the dollar had risen sharply and this had placed pressure on the export sector.

This morning it opened sharply lower at US67.37 cents after the US Federal Reserve made its interest rate announcement. The kiwi started to rise after the Reserve Bank raised its cash rate.

"However, as yet this has not had much effect on spending in the local economy," Dr Bollard said.

"In time this will happen, probably reducing the need for interest rates to rise as much as they might otherwise."

Yesterday, dairy giant Fonterra, which produces 20 per cent of the country's exports, blamed the soaring currency for a $650 million fall in sales.

The main commercial banks may not necessarily respond to Dr Bollard's move.

ASB, BNZ, and Westpac all lifted their floating mortgage rates from 7.10 per cent to 7.25 per cent in November and December despite the Reserve Bank not lifting the cash rate.

The ANZ-National, which had earlier left its rates unchanged, also lifted them to 7.25 per cent.

Deutsche Bank chief economist Ulf Schoefisch questioned why Dr Bollard felt the urgency to move now, especially with immigration cooling and the housing market plateauing.

"We didn't think they were under any pressure to act early, particularly with the currency being strong and early signs that the housing market is cooling.

"I didn't think the urgency was there... particularly as there is always the chance that in four weeks time we will have the kiwi at US70 cents."

"In that situation, you just wonder if a tightening cycle is necessary," said Dr Schoefisch.

"Obviously, the Reserve Bank is very worried about inflation and inflation is sitting at 1.6 per cent. But the RB doesn't believe it is going to stay there for long."

Dr Schoefisch said the RB was obliged, now a tightening cycle had been started, to deliver another tightening in March.

"It really depends on the currency. Beyond that (March) it is not obvious to me that there will be further rate hikes in April and June."

He doubted today's hike would crimp economic growth, which Deutsche Bank, now expects to be around 2.75 per cent this year against 3.50 per cent last year.

Deutsche Bank expects the New Zealand dollar to rise above US70 cents in the next few months.

"What it means is that foreign investors can look forward to continued higher interest rates here that are higher than expected in the short term," said Dr Schoefisch.

He noted the New Zealand dollar had already gone up on the cross rate against the Australian dollar. New Zealand's cash rate rise puts into line Australia's official rates.

"The rate rise will just underpin the strong currency and just underpin the pressure on the export sector."