By Tracy Withers June 10 (Bloomberg) -- New Zealand’s central bank raised its benchmark interest rate for the first time in three years, signaling that faster inflation is a bigger threat to growth than further gains in the nation’s currency. “Underlying inflationary pressures are expected to increase,” Reserve Bank Governor Alan Bollard said in a statement released in Wellington today after increasing the official cash rate to 2.75 percent from a record-low 2.5 percent. “Given the current low level of the cash rate, it is therefore appropriate to gradually remove policy stimulus.” Inflation is forecast by the central bank to soar to 5.3 percent next year as an increase in sales tax boosts prices. New Zealand’s dollar, the best performer after the yen among Group of 10 currencies over the past year, gained as investors bet higher interest rates may strengthen demand for the so-called kiwi, even as Bollard last month said a gradual depreciation “remains desirable.” “We’re going to see more rate rises from the bank this year” which will support the kiwi, said Mike Jones, a Wellington-based currency strategist at Bank of New Zealand Ltd. “The statement is being interpreted as a bit more hawkish than the market had anticipated.” New Zealand’s dollar bought 67.13 U.S. cents at 12.22 p.m. in Wellington from 66.71 cents immediately before the central bank’s statement. Today’s move was expected by 13 of 15 economists surveyed by Bloomberg News. Two forecast no change. Bollard, who kept the benchmark rate unchanged since April 2009, last raised borrowing costs in July 2007. ‘Powerful Impact’ “The bank expects the removal of stimulus to have quite a powerful and rapid impact on the economy,” Bollard said. “The further removal of stimulus will be reviewed in light of economic and financial market developments.” The Reserve Bank expects it won’t need to raise the cash rate as high as in previous cycles because bank funding costs are higher, long-term interest rates are higher than short-term interest rates, and a greater proportion of borrowers use floating rate mortgages, he said. Higher interest rates may spur demand for so-called carry trades, in which investors borrow in low-interest-rate currencies to buy better-yielding assets in New Zealand, buoying the local currency. New Zealand’s dollar has gained 6.3 percent against the U.S. dollar in the past 12 months because its cash rate remains attractive compared with the Federal Reserve target of zero to 0.25 percent and the 0.5 percent base rate in the U.K. Carry Trade “The carry trade is there although one could make the case it is less attractive at the moment than Australia where interest rates are a full 2 percentage points higher than ours,” Prime Minister John Key, the former head of foreign exchange at Merrill Lynch & Co., said in an interview June 1. Bollard’s decision is in contrast with central banks in Indonesia, the Philippines and Thailand who kept borrowing costs unchanged last week because of Europe’s debt crisis. Australia’s central bank on June 1 also kept its overnight cash rate target unchanged, pausing after six increases since October. Bollard, who is required to keep average inflation between 1 percent and 3 percent, faces a more immediate threat from rising prices. Sales Tax On May 20, Finance Minister Bill English announced the nation’s sales tax rate would rise to 15 percent from 12.5 percent effective Oct. 1, boosting all prices by slightly more than 2 percent. The government had previously increased taxes on tobacco, while a plan to levy carbon emissions will boost fuel and power costs from July 1. Inflation is expected to peak at 5.3 percent in the year ending June 30, 2011, and decline thereafter, the central bank forecast today. Prices increased 2 percent in the year ended March 31, 2010. By March 2012 inflation will reduce to 2.8 percent, matching the bank’s previous forecast, it said. Excluding the government policy changes, the peak will be 2.6 percent. “Underlying inflation is expected to track within the target range even as the economy expands further,” Bollard said. “Provided households and firms do not reflect the price spike in their wage and price-setting behavior we do not expect a lasting impact on inflation.” Commodity Prices New Zealand’s economy will accelerate this year as commodity prices increase, the labor market improves and business investment picks up, the central bank said. “New Zealand’s export commodity prices have increased sharply over the past few months, boosting export incomes,” Bollard said. Exports make up 30 percent of the economy. Fonterra Cooperative Group Ltd. in Auckland, the world’s largest dairy exporter, forecast May 25 that it would pay its 10,500 farmers 8.2 percent more for milk in 2011, spurred by “strong” demand from China, the rest of Asia, the Middle East and North Africa. The group accounts for about 40 percent of the global trade in butter, milk powder and cheese. Still, the central bank assumes that farmers who benefit from higher prices will reduce debt rather than spend, adding to the caution already evident amongst consumers and businesses. It forecasts private consumption growth will slow over the next two years, and the housing market will be subdued. As a result, gross domestic product will increase 3.8 percent in the year ending March 31, slower than the 4.4 percent annual pace forecast in March, the central bank said. Growth will slow to 2.9 percent in the year through March 2012. Unemployment New Zealand’s jobless rate declined to 6 percent in the first quarter from 7.1 percent the previous three months. The central bank expects employment increased by 33,000 in the first half of 2010. Demand for finance is likely to increase as the domestic recovery progresses and it is important creditworthy companies and consumers can borrow on reasonable terms, Bollard said. He expects a recent tightening in lending standards will be eased, which may buoy investing and spending. “We see recovery, but it’s likely to take time,” Warehouse Group Ltd., the nation’s largest discount retailer, said in a presentation to investors last week. Consumer sentiment may hinge on more jobs in the economy, which will buoy incomes and offset increases in interest rates later this year, the Auckland-based company said. The G-10 covers the most-traded currencies against the U.S. dollar among developed nations. These include the pound, the yen, the euro, the Canadian, Australian and New Zealand dollars, the Swiss franc, and the currencies of Denmark, Sweden and Norway. To contact the reporter on this story: Tracy Withers in Wellington at twithers@bloomberg.net.

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