Inflation on RBNZ's radar as cash rate hiked

The Reserve Bank of New Zealand stuck to its pledge of removing monetary stimulus around the middle of 2010 and made the first hike in its cash rate since the global financial crisis to ensure "robust" growth does not increase inflationary pressures in the economy.

The official cash rate was yesterday raised to 2.75 per cent from an all-time low of 2.50 per cent. The rate hike was accompanied by a sharp increase in the RBNZ's average inflation projection to 4.8 percent in 2011 from just 2.3 per cent in the previous statement, as new estimates incorporate the effects of the government's emissions trading scheme.

The motive behind the hike can be summed up in Governor Alan Bollard's own words: "New Zealanders would be pretty disappointed if a year out we suddenly had to really start pushing up rates because we had been behind the inflation story and they were starting to see savings inflated away.

"We had to take a medium-term view on this and we are required to do so in our policy targets."

The RBNZ believes GDP growth will remain robust over its projection due to gains in export volumes and an eventual recovery in residential and business investment.

"This growth is likely to see underlying inflationary pressures increase. As such, given the current low level of the OCR, it is appropriate to gradually remove policy stimulus."

Surprisingly, even as the RBNZ talked about robust growth, it lowered its GDP estimate for 2011 to 3.5 per cent from 3.8 per cent earlier, for 2012 to 3.6 per cent from 3.9 per cent earlier and for 2013 to 2.0 per cent from 2.4 per cent before.

Within that slower but robust growth, RBNZ is confident that resource slack in the economy will be eliminated over the coming year and cause underlying inflationary pressure to increase.

Bollard expects to continue to gradually remove policy stimulus but has cited three key assumptions on which the gradual removal is based. The chief among them is an assumption that the coming temporary increase in inflation will have limited impact on medium-term inflation expectations.

This suggests rate hikes could be faster if inflation expectations increase more than the RBNZ's estimates. Other assumptions include continued consolidation of balance sheets by households and firms, and robust trading partner growth.