The Reserve Bank is leaving the official interest rate steady at 2.5 per cent and expects to keep it "unchanged through the end of the year".

But a softer than expected line on inflation and a reminder that rate cuts were possible if the dollar stayed high, saw interest rates dip and the currency drop more than half a cent, to under US81.9c.

In its Monetary Policy Statement issued this morning, the central bank said there were "both upside and downside risks to the [economic] outlook".

But the bank's projections pointed to the first interest rate rise not coming till well into next year, implying the first rise in September 2014, before gradually rising to about 4 per cent in 2016.

ASB Bank economists said they continued to expect the Reserve Bank to keep rates on hold till March 2014 before gradually rising to 4 per cent.

Westpac stuck with its pick that rates would start to move up in December, because of rapidly rising house prices and the Canterbury construction boom.

While the Reserve Bank appeared to take a balanced view on the risks, Westpac said the statement leaned more to the downside because of the high currency. In an alternative scenario, the Reserve Bank said if the currency were to remain at its current high level to the end of 2014, the official cash rate could well be cut.

Westpac said that was the first acknowledgment that the next move in the cash rate could be down, and was the main reason for interest rates to fall and the currency to drop.

"We were surprised by the dovish tone of this statement," Westpac said.

The statement saw two-year swap rates drop 10 basis points, which Westpac said could lead to lower mortgage rates.

"This will stimulate the housing market further, an unhelpful development for the Reserve Bank," Westpac said.

The central bank warned again about rising house prices, but noted the impact of the growing drought.

The Reserve Bank also pointed to the "overvalued" New Zealand dollar, which was undermining profits in export and import-competing industries.

"Worsening drought conditions are creating difficulty in much of the country," Governor Graeme Wheeler said.

"Hot dry weather has resulted in challenging farming conditions in much of the country, with drought declared in many parts of the North Island," the statement said.

Milk production was likely to be significantly affected in the second half of the season.

"Continued drought would have a marked negative impact on aggregate economic output," the bank said.

The Reserve Bank cut its growth forecasts back 0.2 to 0.3 per cent for the first half of this year because of the drought, with the risk of a bigger impact if there is no rain soon.

ASB Bank economists said that was conservative, and expected the drought to slice 1 per cent off growth for the full year.

The Reserve Bank's commentary on the drought was relatively brief, given the drought was officially declared after the Reserve Bank finalised its forecasts.

Government belt-tightening would also slow overall demand. But the downside risks around global growth had lessened in recent months and financial market sentiment had improved. The domestic economic recovery remained uneven.

Demand and business output were rising, but the job market remained weak, with unemployment still close to 7 per cent.

The Canterbury rebuild, after the earthquake two years ago, was gaining momentum. House building and business and consumer confidence were lifting.

"House-price inflation is increasing," Wheeler said.

House prices rose about 6 per cent last year, and were forecast by the central bank to rise 6.2 per cent this year and 3.6 per cent in 2014, before levelling off.

"The bank does not want to see financial stability or inflation risks accentuated by housing demand getting too far ahead of supply," Wheeler said.

Inflation was presently subdued, up just 0.9 per cent last year and under the bank's target band.

Inflation was likely to remain low in the near term, only rising back to 2 per cent a year by late 2015.

But the central bank pointed out that inflation was low mainly because of a high New Zealand dollar.

The Reserve Bank's projection for 90-day bank bill rates is for it to remain steady at 2.7 per cent this year, but starting to rise in the June quarter of 2014, and only gradually rising to 4 per cent by early 2016.

An indicator of short-term interest rates, the track for 90-day rates is slightly flatter in the near term than it was in the December statement, but rising a bit faster after 2014.

Quarterly economic growth is projected to improve this year, reaching 0.9 per cent in the December quarter, but with the pace easing back slightly by late 2014.

Over the coming years, economic growth was projected to strengthen to about 3 per cent a year, as a result of the Canterbury rebuild, wider house building, and "continued low interest rates", the statement said.

Since the December Monetary Policy Statement there had been signs of better-than-expected economic growth.

Demand in the coming year would be boosted by the Canterbury rebuild and a "more widespread" lift in home building, and continued low interest rates.

Average mortgage rates are down about 45 basis points over the past year, or almost 0.5 per cent.

While that better overall growth would be partly offset by government belt-tightening, and a high currency, stronger domestic demand would add to medium-term inflation pressures.

Monetary policy would remain focused on keeping future average inflation near the 2 per cent target midpoint.

- © Fairfax NZ News

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