Bollard warns tax cuts will increase inflation pressure

By NZPA

Thursday 25th October 2007

Reserve Bank Governor Alan Bollard has left interest rates unchanged while warning that tax cuts or increased government spending would add inflationary pressure.

Leaving the official cash rate (OCR) at 8.25% today, Bollard also warned that a proposed greenhouse emissions trading scheme and rising global food prices threatened to push up inflation.

In a bid to hold inflation to its target band of 1 to 3%, the central bank lifted the OCR by 1% point in four steps between March and July.

It had been particularly concerned at the strength of the housing market, but in its mid-September statement said it was starting to see signs of cooling in domestic spending.

Today, Bollard said there were signs the housing market was moderating but noted other indicators of inflationary pressure.

"The labour market remains tight, domestic income growth continues to expand on the back of strong commodity prices, and core inflationary pressures persist," Bollard said.

"Despite ongoing surpluses in the Government's operating balance, fiscal policy is contributing to inflationary pressure. Any further easing in fiscal policy beyond that already announced will add further upside risks to medium-term inflation.

"There are a number of upside risks to inflation, including the direct effects of the proposed greenhouse emissions trading scheme and rising global food prices," he said.

"While the turbulence in global financial markets has eased somewhat, considerable uncertainty remains. This poses a downside risk for our key trading partner economies.

"In addition, the New Zealand dollar remains relatively high, restraining the externally-focused sectors of the economy," Bollard said.

"We believe that the current level of the OCR remains consistent with future inflation outcomes of 1 to 3% on average over the medium term."

New Zealand's annual inflation rate dropped to 1.8% in the third quarter from 2% in the previous quarter. But that fall was largely due to one-off factors and the annual rate is expected to move towards 3%.

The strength of the economy has caused some concern, with gross domestic product expanding a seasonally adjusted 0.7% in the June quarter, topping the 0.5% forecast by the Reserve Bank.

Some economists have predicted the Reserve Bank will have to lift interest rates further to hold inflation, but most are picking the next move will be a cut, although not for some time.

ANZ economist Khoon Goh said it was a "really a balanced statement, they (the Reserve Bank) are in neutral mode and they're seeing the world evolve pretty much in line with their central view in September. Obviously they're still worried about inflation".

Goldman Sachs JBWere economist Shamubeel Eaqub also saw the Reserve Bank as having a "broadly neutral tone, with current interest rates consistent with the medium term inflation rate".

But hawkish undertones remained, highlighting the upside risks to inflation from such things as food prices, he said.

"There's no real change in the Reserve Bank's position, we think the economy will need to slow further from here for them to be comfortable with its view.

"We think interest rates will ease from here as the housing market broadens into a more widespread slowdown."

UBS senior economist Robin Clements said that even if the conclusion was neutral on rates the undercurrent was a bit more hawkish.

"If you write a list of things that are upside risks to the Reserve Bank: inflation, labour market, commodity prices, food prices and so on, they tend to outweigh the other things such as the housing market global uncertainty," he said. "If one of these things breaks out, then you could say there's the risk of a hike, but as it stands I think we'll go for a while with rates on hold."

The New Zealand dollar briefly dipped about 10 basis points before settling around its pre-announcement level of US75.40c.

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