June 7 (Bloomberg) -- New Zealand's central bank unexpectedly raised its benchmark interest rate a quarter point to a record 8 percent, saying housing demand and consumer spending are fanning inflation. The currency rose to a 22-year high.

``A sustained period of slower growth in domestic activity will be required to alleviate inflation pressures,'' Reserve Bank Governor Alan Bollard said in Wellington today. A 60 percent surge in world prices of dairy products the past six months has boosted farmers' incomes and will stoke inflation next year, he said.

Bollard's third rate increase since March is buoying New Zealand's dollar as investors are attracted to a benchmark rate second only to Iceland's among countries with the highest credit rating. The yield gap with Japan widened to 7.5 percentage points, boosting returns for investors who borrow yen to invest in New Zealand dollars, known as a carry trade.

``You would think that the carry trades will remain very much in force,'' said Shamubeel Eaqub, an economist at Goldman Sachs JBWere Ltd. in Auckland. ``The absolute spread between New Zealand and international interest rates is still very, very high.''

The New Zealand dollar rose to 75.67 U.S. cents, the highest since it began freely trading in March 1985, from 75.12 cents before the statement. It bought 75.63 cents at 4:47 p.m. in Wellington.

There is a 28 percent chance of a quarter-point rate increase at the next central bank review on July 26, according to an index calculated by Credit Suisse, based on interest-rate swaps trading. One of 10 economists surveyed today expects a quarter-point increase in July. The other nine expect no change this year.

Inflation Target

Bollard isn't alone in raising rates to combat inflation. The European Central Bank yesterday raised its benchmark to a six-year high of 4 percent. The Bank of England's benchmark rate is at a six-year high of 5.5 percent after four increases in the past year, most recently on May 10.

The Reserve Bank of Australia yesterday left its benchmark at a six-year-high 6.25 percent. Futures traders have priced in another Australian increase by the end of this year, which would take the rate to a 10-year high.

Bollard is required to keep inflation between 1 percent and 3 percent. Annual inflation will slow to 2.2 percent by March next year and then accelerate to 2.8 percent by March 2009, the Reserve Bank said. Consumer prices rose 2.5 percent in the 12 months ended March 31, 2007.

Just three of 14 economists expected an increase in the official cash rate today. Eleven forecast no change.

Soaring Currency

In the past year, the local dollar gained 21 percent against the U.S. dollar, the best performer among the world's 16 most- traded currencies.

``The exchange rate is at levels that are both exceptionally high and unjustified on the basis of New Zealand's medium-term fundamentals,'' Bollard said.

Rising interest rates are ``inflicting significant damage'' on exporters, said Jeffrey Wesley, chief executive officer of Turners & Growers Ltd., New Zealand's largest fresh fruit exporter.

``Any increase is bad because it encourages more foreign money to come in thereby pushing up the exchange rate,'' Wesley said in an interview from Auckland.

Dairy products such as milk powder, butter and cheese are New Zealand's biggest exports, followed by meat. Exports make up 30 percent of the nation's $102 billion economy. Tourism accounts for 10 percent.

Farm Incomes

Fonterra Cooperative Group Ltd., the world's biggest dairy exporter, said on May 23 it will pay farmers 27 percent more for milk this year as global prices rise. The central bank estimates the increased payments will add almost $NZ2 billion ($1.5 billion) to dairy farm incomes in the next two years.

``The rise in dairy sector incomes will provide a substantial boost to economic activity over the next few years, but will also add to inflation pressures,'' Bollard said.

Economic growth will accelerate to 3.1 percent in the year ending March 31, 2008, from 1.7 percent a year earlier, the central bank said in economic forecasts also released today.

``Housing market activity has been buoyant, consumer confidence has remained relatively robust and a range of business sector indicators including employment and investment intentions have been strong,'' Bollard said.

Home sales rose 8.1 percent in April from a year earlier, according to a May 16 report from the Real Estate Institute of New Zealand Inc. First-quarter retail sales rose at the fastest pace since records began in 1995.

Economic Growth

Bollard increased rates nine times between January 2004 and December 2005. A 15-month pause ended in March when he said inflation may have accelerated beyond the top of his target range unless he increased borrowing costs.

``Had we not increased rates this year, it is likely that the inflation outlook would now be looking uncomfortably high,'' he said. Today's increase ``is to ensure that inflation outcomes remain consistent with achieving the target.''

Signs are emerging that economic growth may slow. Just 29 percent of companies surveyed by ANZ National Bank last month expect sales will rise in the next 12 months, the weakest confidence reading since August.

The outlook for hiring, investment and exports suggests economic growth may be 1 percent this year, or a third of the pace Bollard forecast in March.

To contact the reporter on this story: Tracy Withers in Wellington at twithers@bloomberg.net.

Last Updated: June 7, 2007 00:53 EDT