Economic growth and inflation have been stronger than the Reserve Bank expected just six weeks ago, Reserve Bank governor Graeme Wheeler says.
But the New Zealand dollar has also been higher and there are signs the housing market is cooling, he said in a speech to the Canterbury Employers Chamber of Commerce in Christchurch today.
The central bank yesterday left official interest rates on hold at 2.5 per cent, but sent a strong signal that rates would rise soon, without setting a firm date.
Most economists say a rise in March is almost certain.
In his speech today, Wheeler painted a picture of a strong economy, boosted by the Canterbury rebuild, high commodity prices and strong consumer and business confidence.
While there were "initial indications" that house-price rises had started to moderate since the introduction of restrictions on low-deposit home loans late last year, it was too soon to draw "firm conclusions".
Wheeler warned that the level of house prices was a "risk to expansion".
He repeated that New Zealand house prices were overvalued, with a recent OECD report suggesting they were 25 per cent above long-term averages, while rents were 60 per cent above.
Households also had high debt levels, at about 150 per cent of household disposable income.
A big fall in house prices was "unlikely", but Wheeler warned that could happen if there was a big fall in borrowers' ability to pay interest if unemployment got worse, incomes dropped or interest rates became "very high".
A sharp drop in house prices would probably be accompanied by a domestic recession.
Wheeler also had another crack at the high dollar.
"The exchange rate remains a considerable headwind for the economy and the bank does not think its current level is sustainable in the long run," he said.
He also repeated yesterday's comments that inflation pressures were rising and that interest rates would need to return to "more normal levels" to keep future inflation "near the 2 per cent target midpoint".
But the scale and speed of the rise in the cash rate would depend "on future economic indicators", he said.
While headline inflation had been "moderate" he warned that inflationary pressures were building and were expected to increase in the next two years.
"In such an environment, there is a need to return interest rates to more normal levels and the bank expects to begin this adjustment soon," he said. In December, the Reserve Bank suggested interest rates would rise about two percentage points over the next two year.
Several forces were behind New Zealand's economic recovery, Wheeler said.
The international economy was recovering after many years of "fragility and uncertainty".
New Zealand's terms of trade were the highest since 1973. Farmers were enjoying "very favourable" export commodity prices and an excellent grass growth season.
New Zealand was getting a strong boost from its export links with the rapidly growing Asian markets, especially China.
Construction was also strong in New Zealand, with investment up 40 per cent in the past two years, largely due to the Canterbury rebuild.
The Canterbury rebuild was forecast to cost about $40 billion, or about 20 per cent of GDP in total.
"It will have a major impact on the local and national economy for a number of years to come," he said.
The rebuild would peak at about $4b a year in 2016 and 2017.
If the targets for house building in Auckland were also met in the next three years and 12,000 new homes were built in Christchurch, then construction volumes would need to be 10 per cent higher than in 2004, during the last building boom.
But Wheeler warned that price pressures were "particularly apparent" in the construction sector and spare capacity was being absorbed at a rapid rate.
Such pressures could spill over into broader consumer-price inflation.
There were signs the increase in the cost of construction in Canterbury was starting to spill over into other sectors and regions.
Building costs had been steadily rising in Auckland and the rest of the country in the past 12 months.
- Fairfax Media