Reserve Bank Governor Bollard outlines RBNZ thinking on inflationary pressures from Christchurch rebuild, talks about interest rate outlook

The Official Cash Rate is likely to stay on hold at 2.5% until the downside risks to economic growth from the Canterbury earthquakes, and the more broad fragility of the New Zealand economy subside, Reserve Bank Governor Alan Bollard says.

In an op-ed piece for the Christchurch Press today, Bollard outlined the central bank's thinking on the inflationary pressures that will appear due to the rebuilding of Christchurch, and its outlook for raising the OCR, saying: "we should respond to any medium-term generalised inflationary pressures that are likely to develop as resources are devoted to reconstruction in Canterbury," with reconstruction picked to begin in earnest in 2012.

Bank economists are divided as to whether the RBNZ would have to hike the OCR from its record low in December, before the year is out, or whether it would be able to hold at 2.5% until the first, or even second, quarter of 2012.

'Already seeing stabilisation'

The OCR cut in March, along with government support programmes, appeared to have been helpful in stabilising confidence, and the Reserve Bank would expect the deterioration in economic activity due to the quakes "to be arrested by mid-2011," Bollard wrote.

"In Canterbury, activity can be expected to lift because of resumption of business activity, replacement spending and government support. But the Canterbury economy will remain subdued as a result of wealth losses, weakness in tourism and construction, and obstacles including damage to infrastructure and capital. Nonetheless, recovery in the Canterbury economy, combined with the boost from the Rugby World Cup, will result in a marked pick-up pace of overall GDP growth," Bollard said.

"The reconstruction phase is expected to begin in earnest next year, with residential and non-residential investment lifting growth sharply," he said.

'Inflation pressures to pick up'

Spare capacity and labour would be absorbed rapidly, and inflation pressures would pick up from current low levels, prompting interest rates increases, Bollard said.

"The likely drivers of inflation from a reconstruction such as we will see in Christchurch are the demand and supply of labour, materials and equipment, and the availability of finance. How government policy affects regulatory standards and the rebuild is also clearly important," he said.

"How will the Reserve Bank deal with this? We are guided by our Policy Targets Agreement (PTA) with Government that says, in the case of natural disasters, we should accommodate any initial inflation effects, such as higher rents or insurance premiums. However, we should respond to any medium-term generalised inflationary pressures that are likely to develop as resources are devoted to reconstruction in Canterbury," Bollard said.

"This means assessing the extent to which wages, construction costs and other prices rise nationally, as resources are drawn into the Canterbury region," he said.

"At the same time, monetary policy should also look to avoid any unnecessary instability in activity, the exchange rate and interest rates resulting from the earthquakes. This consideration was behind the decision to reduce the OCR in March so as to mitigate the near-term negative impact of the February quake.

"It is appropriate for monetary policy to remain supportive, given the continued downside risks to economic activity stemming from the Canterbury quakes and more broad fragility in the New Zealand economy. It is likely that the OCR will remain on hold until these downside risks pass and the economy begins to recover," Bollard said.