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Opinion: Rates choice easier for Bollard but not straight forward

By Simon Louisson of NZPA

Friday 3rd June 2005

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Alan Bollard said his decision in March to hike interest rates was one of the toughest in his career as Reserve Bank governor.

His decision to leave rates pat at next Thursday's review should be easier - if not easy - following this week's business confidence survey .

The National Bank's monthly survey of business showed confidence has slumped to a 17-year low, with 62% of businesses expecting a deterioration in general conditions over the next year.

The last time confidence slid to that level was in the wake of the 1987 sharemarket crash.

More tellingly, the survey of firms' own activity saw net optimism fall to just 9% from 15% the previous month. That index is a strong indicator of future economic growth and the low number points to insipid activity ahead.

Data showing the number of building consents in April were the lowest in over three years, suggested the economy has already turned down.

While the decision may appear straightforward, Bollard faces a number of conundrums on Thursday.

Firstly, a change in monetary conditions is supposed to take 12-18 months to affect the economy. So even though inflation is close to the top of the bank's 1%-3% target, Bollard should be looking through that towards the forecast sluggish growth rate of 2% to 2.5%.

Deutsche Bank chief economist Ulf Schoefisch said any attempt to drive using the rear-view mirror and concentrate on what has just been was a risky approach to setting monetary policy.

But the Reserve Bank is likely to argue a backward-looking approach is justified given that inflation is running close to 3% and the risks are considerable, given the tight labour market and high capacity utilisation, that inflation is stuck up there for some time.

Another problem for Bollard is that while his seven interest rate hikes since the start of last year have cranked up short term interest rates, longer bonds, and therefore two and three year fixed mortgages, have been falling. Lower mortgage rates are fuelling the housing market, one of the main drivers of inflation.

Bond yields have dropped largely because global bond rates, particularly in the US, have fallen, as the picture for the world economy has dimmed.

Recent European economic data has been very weak and doubts about the US economy are increasing. US 10-year bond yields have fallen below 4% again, suggesting markets do not think the US economy is all that strong and the Federal Reserve won't tighten US rates much more.

That, says Dr Schoefisch, is a seachange from only a few months back.

"People have lost confidence in the global growth story.

"The global environment has deteriorated, there is more uncertainty generally and domestically confidence has dropped quite a bit. It's not usually an environment you would hike interest rates."

However, another major conundrum Bollard faces is that he knows he must eventually loosen the interest rate stranglehold but he can't signal it in advance. If he does, the markets will anticipate it immediately and that may unleash another buying frenzy in the housing market that will rekindle inflation pressure.

So he has little alternative but to talk tough even if he doesn't mean it.

"The problem is if you talk tough and don't follow up, then credibility wears off," said Schoefisch.

"I think they will next Thursday re-iterate their tightening bias but the market will say `how likely is that they tighten?"'

To maintain credibility Bollard may have to actually tighten and risk slamming the economy into the dreaded "hard landing".

A weaker outlook for the world economy will result in weaker commodity prices, putting further pressure on the export sector already struggling with the strong currency.

Some relief came with the fall of the New Zealand dollar below US70c this week and that drop could be a turning point for the currency. However, the fall was as much to do with euro weakness than local factors.

However, it poses another dilemma for Bollard. A fall in the dollar may help exports but will be inflationary - pushing up import prices for items such as petrol and putting more spending power in the hands of exporters such as farmers.

Even without another rate hike, Schoefisch believes Treasury's growth forecasts in last month's budget - predicting growth to slow to 2.3% next year then recovering to 3.5% in 2008 - are too rosy.

He thinks the slowdown will be more pronounced and drawn out as the lagged effects of the seven rate hikes bite.

"There's not too much on the horizon to show the economy will recover very quickly."

In spite of all that, he expects Bollard has little choice but to maintain "tightening bias" to the outlook for monetary policy.

"If you look at the overall picture, the arguments for another rate hike are weaker this time. The business survey highlights that there are significant downside risks to the economy going forward beyond the slowdown that the Reserve Bank is expecting anyway.

"But I think the Reserve Bank will err on the side of caution basically saying, `we want to see clear evidence that the inflation cycle is following downwards as well'. That evidence may not be there until early next year."

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