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NEWSFLASH: Reserve Bank Has An Each Way Bet

NEWSFLASH: Reserve Bank Has An Each Way Bet

The economy could be inflationary, or it could be deflationary. That was the message from Reserve Bank Governor Don Brash this morning, who announced, as expected, that the bank will not increase interest rates.

Having a punt each way Dr Brash says in his three monthly Monetary Policy Statement this morning that the bank is essentially taking a wait and see approach to economic conditions.

The decision not to raise interest rates - which is contrary to earlier (but not more recent) market expectations - follows a subdued June Quarter for the NZ economy during which the Reserve Bank is picking a technical recession. Official June Quarter GDP figures are due out shortly.

"One school of thought suggests that, given continuing growth in our major trading partners, moderate interest rates, and an exchange rate which is close to historical lows, economic activity and business confidence will bounce back strongly before long", Dr Brash said in his policy overview statement this morning.

"This view of the world sees the prospect of significant inflationary pressures next year, and a need for the Bank to keep increasing interest rates.

"Another school of thought suggests that business confidence may take a considerable time to recover fully, and any significant slowdown in major markets such as Australia and the United States could exacerbate an already difficult situation."

The uncertainty over the future path of the NZ economy arises because of what Dr Brash describes as, "dichotomous" and "divergent", scenarios.

The situation, he says, is similar to what it was in the mid 1990s, only the dichotomy has been reversed.

"This time it is the rural sector and exporters who are enjoying a period of relative prosperity, while urban NZ is struggling with flat or declining house prices, increased interest costs on bigger mortgages, increased petrol prices, and the higher tax rate on earnings over $60,000," the bank comments in its statement.

So on the one hand we have a booming export sector, a competitive exchange rate and the prospects of strong growth in the short-term world wide. On the other we have a debt laden domestic household sector, and business and consumer confidence in the doldrums.

Put another way, the cockies are rolling in it and the townies are suffering. The only question is: who's circumstances will end up driving the future of the economy as a whole?

With June GDP results so clearly out of line with previous expectations - the bank is forecasting a 0.2% contraction compared to 1% growth forecast in May - the Reserve Bank is left to make a line call on this question that it appears not to want to make.

"Clearly, the data on economic activity in a small economy such as ours tend to be "noisy", and the Bank needs to steer through that noise as best it can," Dr Brash concludes.

" Given the uncertainty about the outlook, leaving the Official Cash Rate unchanged seems the prudent thing to do right now. "

Business and political leaders can be expected to agree with Dr Brash on this point at least.

The decision not to move rates is largely in line with market expectations and is not expected to have a major impact on interest rates and the dollar today.

That said, before the statement was announced the Kiwi had already fallen overnight to new 15 year lows of around 50.8 on a TWI basis. The kiwi is now comfortably under the 45 US cent mark. The recent falls in the dollar do not appear to be related to Reserve Bank interest rate policy.

Notably the Reserve Bank forecasts show a TWI average of 51.9 for the second half of this year and of 54 for the first half of next year. These would appear to be heroic assumptions at this stage.

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