(Bloomberg) -- New Zealand’s central bank is prepared to raise interest rates if economic developments mean current policy settings aren’t restrictive enough to bring inflation back to target, Assistant Governor Karen Silk said.

“There are risks still to the upside in the near term” and the bank is “absolutely” prepared to act if they were to “come to fruition in a meaningful way,” Silk said in an interview Friday in Wellington. “Right now we are saying that the level of restrictiveness is there, but we are awake at the wheel.” 

The Reserve Bank left the Official Cash Rate at 5.5% this week but surprised markets by saying it considered a hike and that policy needs to stay restrictive for longer because of domestic inflation pressures. The bank’s forecast rate track implies a 60% chance of an increase this year and no pivot to easing until the second half of 2025.

After the RBNZ’s rate decision, investors reduced bets on a rate cut this year while most local economists now see no easing until next year.

To be sure, Silk said there are also risks to the downside. 

New Zealand’s economy was in recession in the second half of 2023 and the RBNZ expects just 0.4% annual average growth this year. That has implications for company earnings and unemployment, which could cool inflation.

“The labor market could unwind faster if business profitability is squeezed and they stop hoarding labor,” Silk said. 

The RBNZ’s central projection is that headline inflation will fall back into its 1-3% target band by the fourth quarter this year, though it now doesn’t see it reaching its 2% goal until mid-2026.

“If we don’t continue to see inflation come back at a reasonable pace, what does that mean for inflation expectations?” Silk said.

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Silk said domestic inflation is more persistent than expected while it appears the economy has less capacity to grow without putting pressure on prices.

“Our concern is in that near term, around what are we really seeing in terms of domestic aligned inflation,” she said. “Is it going to come back at the pace that we need it to?”

The RBNZ has underestimated non-tradables inflation, the best measure of domestic price pressures, for four straight quarters.

Silk said the most significant miss was last quarter, when non-tradables inflation was 5.8% compared with the RBNZ’s 5.3% projection.

She said the mis-read reflected small discrepancies across the board, which “is more concerning than if it had been any one particular thing.”

RBNZ officials have now assessed that there were more capacity pressures in the economy than they had previously realized and have adjusted their modeling accordingly. 

The RBNZ projects non-tradables inflation will be 5.3% in the current quarter and sees it gradually slowing to 2.8% by the end of 2025. A fifth straight mis-read wouldn’t necessarily be a problem, Silk said.

“We don’t look at just one thing,” she said. “It will be in the context of a broader mix of measures. But it is an important measure that we will be watching. And we will be watching labor market data as well. We need to see that continue to soften.”

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