The Reserve Bank today said it expects the inflation rate to leap to 4.7% this year, the highest level in 18 years, but bank governor Alan Bollard still signalled a cut in interest rates.
As expected, he left the official cash rate (OCR) unchanged on 8.25% today.
He painted a bleak picture of the economy and because of that said the bank would cut the OCR later this year despite the rampant inflation.
The forecast cut "is sooner than previously envisaged".
The news sent financial markets into a spin with the New Zealand dollar plunging more than one US cent to US77c while September bank bill futures rallied 20 basis points.
Independent economist Donal Curtin predicted the New Zealand dollar would "fall like a stone.
"It will be one way traffic," he predicted.
ANZ Bank chief economist Cameron Bagrie said it was "very encouraging" to see Dr Bollard look through the near-term inflation spike and use the full flexibility of his agreement with the Government to contain inflation.
"Bottom line is that we're not getting any growth so that means the medium term outlook for inflation is better and in that situation the Reserve Bank can take an appropriate monetary policy response, which it looks like they're prepared to do."
But Westpac economist Sharon Zollner said the bank was too pessimistic on growth which it predicted at only 0.9 % in the year to March 2009.
"They're picking a slowdown that's much longer than New Zealand typically sees," she said.
Dr Bollard said the economy faced "the uncomfortable combination of rising inflation and weak economic growth" -- often referred to by economists as stagflation, although he denied that was what is occurring.
"These costs shocks and their adverse consequences are very challenging for the Reserve Bank and for many central banks around the world that are currently grappling with the same low growth/rising inflation scenario."
The bank assumes the NZ dollar trade-weighted index will fall 14 % over three years but said there was a significant risk it could fall even more rapidly.
A steady fall was desirable but a steep fall was not, Dr Bollard said.
The bank projects wholesale interest rates -- 90 day bank bills -- to fall from around 8.8 % to 8.1 % in the first half of next year, and to 6.7 % by the second half of 2010.
"One of the reasons we are not projecting even more easing in monetary conditions is because the experience of the 1970s warns us of the danger associated with easing monetary conditions too rapidly in the face of sharp oil price increases," the bank said.
The soaring inflation rate, already well outside the bank's 1-3 % target range, is blamed largely on oil and food prices while underlying inflation pressures from price and wage rises were persistent.
Dr Bollard denied the bank should have moved sooner to signal an easing, saying that inflation pressures had been too great.
The bank expects economic growth to come to a virtual standstill this year due to household spending hitting the wall and only modestly recover thereafter.
Following 0.9 % growth in the year to March, GDP is seen at just 1.4 % the following year.
Stimulus provided by the Government's tax cuts and new spending announced in the budget would provide some offset to the lower growth but would add to medium-term inflation pressure.
The bank's grim projections include an assumption that house prices will fall from their peak last year by 13 % or 22 % when inflation is taken into account. After the first oil shock in the 1970s real house prices fell 38 %, the bank noted.
Because of the economic slowdown, the inflation rate is expected to come off but still be above the bank's target all through 2010 as household spending contracts over the next two years despite the tax cuts.
The additional stimulus provided by the budget was "relatively small" in the context of other factors in the economy, Dr Bollard said.
The bank should be able to "look through" the first round effects of the breach of inflation target but he issued a warning.
"If firms and workers start negotiating prices and wages on the expectation that inflation at, or above, 3 % is the norm, then the bank would have to respond with higher interest rates than assumed here."
The bank assumes the oil price shock is temporary and prices had peaked although it notes oil futures traders do not assume any such fall. But then the Government's Trading Emissions Scheme will come in, adding to inflation pressures.
Dr Bollard said that in contrast to past economic contractions "we are projecting a relatively long period of low growth".
The weaker economy will see the unemployment rate rise sharply -- from 3.6 % to 6 % in 2011.
