The Reserve Bank is leaving official interest rates unchanged at 2.5 per cent, but is projecting rates will rise more over the two years than expected three months ago.
The improving economy and rising inflation meant the central bank is likely to start pushing up interest rates next year, probably between March and June.
However, the bank did not give a specific date for the first move in today's Monetary Policy Statement.
The bank's projections suggest short term interest rates will rise more than 200 basis points by early 2016. Financial market pricing suggests the first move will come in March 2014, with more than 100 basis points of rate rises during the calendar year.
The central bank also said today that the high New Zealand dollar was not "sustainable" in the long run and was a particular headwind to the export sector.
It said the exchange rate remains "very high" and is higher than it assumed in September, driven up by strong terms of trade and a better economic growth outlook than that of trading partners.
The bank said that its new speed limits on home lending for low deposit loans brought in during October "should help slow house price inflation" but there were limited figures in so far to show the
"The bank will increase the OCR as needed in order to keep future average inflation near the 2 per cent target midpoint," Governor Graeme Wheeler said today.
In the Monetary Policy Statement, the 90-day interest rate is projected to rise over the next few years "by slightly more" than expected in September.
That reflected the view that the terms of trade and domestic demand were somewhat stronger than expected in September. The effect of that was partly offset by a higher exchange rate.
The 90-day bill rate is projected to move from about 2.7 per cent now, to 3.1 per cent by June next year, rising steadily to 4.8 per cent by early 2016. That suggests short term interest rates will rise more than 200 basis points over that period, pushing up mortgage interest rates.
House prices have risen more than 18 per cent in the past two years, fuelled by low interest rates, rising migration and a shortage of homes in regions such as Canterbury and Auckland.
The Reserve Bank's speed limit on low deposit loans was expected to subtract 1 per cent to 4 per cent from annual house price inflation in the first year.
"However, the impact is very uncertain," the bank's statement said.
Buyers with low deposits are being charged about 50 basis points more on their interest rates than borrowers with a bigger deposit.
The cheapest interest rates in the market for borrowers with a large deposit are as low as 4.95 per cent, fixed for six months or a year.
Borrowers are moving out of floating rates and on to fixed term rates.
Floating rate mortgages now make up 43 per cent of lending, down from 56 per cent a year ago.
Almost 75 per cent of borrowers are on either floating or fixed rates of less than a year, which means rising interest rates next year would still rapidly hit interest repayments and take a bite out of household budgets.
With rising interest rates, speed limits on low deposit home loans and a cooling off in migration, house price inflation is expected to cool in the next couple of years.
Wheeler said that the economy was estimated to have grown at more than 3 per cent in the year to September and "the expansion in the economy has considerable momentum".
However economic growth was expected to start losing steam from early 2015, slowing to an annual growth rate of about 2 per cent that year.
The terms of trade are at a 40 year high reflecting booming commodity export prices, especially for dairy products. Household spending is up and construction is rising because of the Canterbury quake rebuild and a response to the housing shortage in Auckland.
But government belt-tightening and a high New Zealand dollar would partly offset the strength of domestic demand, Mr Wheeler said.
"The high exchange rate is a particular headwind to the tradable sector and the bank does not believe it is sustainable in the long run," Wheeler said.
Annual inflation rose to 1.4 per cent in the September quarter and inflation pressures were expected to increase.
But the extent and timing of such pressures would depend largely on moves in the exchange rate, changes in commodity prices and the degree to which the strength in the housing and construction market spills into broader cost and price pressures.
Up till recently, annual inflation has been below 1 per cent for a year. A high dollar tends to reduce inflation and so the need for the official cash rate to be increased.
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