OCR stays the same

The Reserve Bank left official interest rates unchanged at a record low 2.5%, as households remain cautious and business spending is weak.

In comments accompanying a muted Monetary Policy Statement (MPS), published today, Reserve Bank Governor Alan Bollard indicated he continued to expect to start lifting the official cash rate (OCR) around the middle of 2010.

The MPS pointed to a rise in the New Zealand dollar in the second and third quarters of 2009, and an increase in the cost of bank and corporate funding, as factors reducing the level of the OCR needed to achieve a desired level of interest rates for households and firms.

Domestic financial conditions were much tighter than would normally be associated with a 2.5% OCR, the MPS said.

Reserve Bank estimates suggested the marginal cost of bank funding had risen to about 150 basis points above the OCR, from about 20 to 30 basis points before the financial crisis.

Giving itself a pat on the back, the Reserve Bank said the OCR had been held at the record low 2.5% for almost a year, in response to a significant global recession, tight credit conditions, wide interest rate spreads, and a contraction in the New Zealand economy.

Throughout that time, the Reserve Bank had communicated its expectation the OCR would be kept at the current low rate for an extended period, the MPS said.

Those communications helped support an economic recovery by offsetting the tendency for financial markets to quickly price some degree of interest rate normalisation once the OCR reached a peak or trough.

"It appears that these attempts to keep interest rates low were appropriate, given the extent to which the New Zealand economy has contracted and inflation pressures abated," the MPS said.

Recovery in economic activity was expected to build momentum through 2010, with the rebound forecast to be broad-based.

Initially, private consumption was projected to return to its pre-recession level and exports were projected to rise, driven by firmer international demand.

Gross domestic product was forecast to grow 3.2% in 2010 and 4.2% in 2011, the MPS said.

Those rates of growth were lower than historic norms following a recession, reflecting tight credit conditions and attempts by households and businesses to reduce debt.

Bank lending remained weak, with lending to households and the agricultural sector growing only modestly, while business credit continued to decline.

"It seems that this weak credit growth is a reflection of caution by both borrowers and lenders," the MPS said.

House prices were expected to stagnate, with recent strength in prices appearing to have been only temporary, as activity in the housing market was abating.

House prices remained high relative to incomes, and recent rises in mortgage rates would further affect affordability. Potential tax changes may also weigh on house prices in the medium term.

Consistent with the outlook for house prices, residential investment was forecast to be historically weak.

After regaining its pre-recession level, consumer spending was projected to grow slowly, rising 2.8% in 2010, then slowing to just 0.9% in 2012.

Business demand for credit was "very low".

"Our business contacts remain focused on consolidating their balance sheets and protecting cash flows. This balance sheet consolidation has shown through in a significant reduction in aggregate investment and a decline in bank lending," the MPS said.

Current levels of unemployment, combined with efforts by business to contain costs were expected to weigh on inflation in the near term.

In the short term, the amended emissions trading scheme, and increases in ACC charges, would push annual inflation to the top of the Reserve Bank's target range of 3%.

Provided price and wage setters recognised the rise in prices as one-off in nature, and formed their expectations and behaviours accordingly, the implementation of the ETS should not affect medium term inflation, the MPS said.

The Reserve Bank also noted it would welcome fiscal restraint beyond that described in the Government's 2009 budget, once growth became self sustaining.

Such restraint would help reduce the work monetary policy might otherwise need to do.