UPDATE 1-NZ central bank's McDermott says economy improving, still needs support

support@ (Adds more comments from McDermott & economic context)

WELLINGTON, Feb 8 (Reuters) - New Zealand's central bank does not need to raise interest rates even though the economy is running near full capacity because inflation still requires a boost, Assistant Governor John McDermott said.

Moreover, while unexpected strength in the New Zealand dollar in recent months did not alter the policy outlook, a sustained trend higher would be more concerning, McDermott told Reuters.

"Core inflation is sitting a little bit below the midpoint... it still needs a little shove to get it towards the midpoint. That strategy hasn't changed," he said on Thursday.

At its review earlier in the day, the Reserve Bank of New Zealand kept interest rates steady at a record low of 1.75 percent, as expected, and signalled that they were likely to be on hold well into next year.

The central bank targets consumer price inflation in a range of 1 to 3 percent, with a focus on the midpoint. In projections released on Thursday, it forecast the CPI would not reach 2 percent until 2020.

Asked about the risk of inflation rising faster than anticipated given the RBNZ saw no output gap in the economy or spare capacity in the labour market, McDermott said there were a range of risks that meant "there's an equal probability the next move actually could be a cut".

"The broad story is quite nice. Capacity is kind of neutral, inflation expectations are anchored at 2 (percent), inflation is a little bit low, it's looking like it's moving in the right direction," he said.

Key to the RBNZ's assessment were inflation expectations, something that McDermott thought had not been fully understood by markets.

"We are very sensitive to inflation expectations, more so than in the past because businesses are more sensitive to current inflation."


One clear change since the previous review in November has been the New Zealand dollar's strength against the U.S. dollar, which had also lifted it on a trade weighted index (TWI) basis.

The central bank projected the TWI would be around 75 through 2018, up from a forecast of 73.5 in November but below levels from late 2016 to late 2017 when its strength was a policy headache.

"Would we have preferred it to stay where it was in November? Of course," he said, adding the RBNZ was comfortable with the currency's current levels. However, if the uptrend became more established and persisted, "I'd think you'd find the bank would start using different language".

McDermott said upward revisions to gross domestic product data for 2015 and 2016 suggested the "speed limit" for the economy had risen to near 3 percent from around 2.5 percent.

"We've moved the speed limit of what this economy can achieve without generating inflation, and it's moved upwards." (Reporting by Charlotte Greenfield and John Mair Editing by Richard Pullin & Shri Navaratnam)