The economy is heading into 2014 with a lot of momentum.
The rebuilding of Christchurch, Auckland's housing boom,
surging net immigration and the most favourable terms of
trade for 40 years are all boosting the demand side.
Sky-high business and consumer confidence reflects this.
But how long and strong the cyclical upswing will be depends
on what happens to the supply side of the economy, on growth
in its productive capacity underpinned by such factors as
growth in jobs and productivity.
If demand is loping ahead in leaps and bounds but the
economy's capacity to supply goods and services is just
shuffling forward, all the excess demand will deliver is
inflation and a blowout in the trade balance. That would be
unsustainable and the Reserve Bank would need to rein in
At this stage it does not look as if governor Graeme Wheeler
will be brutally yanking the bit.
The bank estimates the economy's "speed limit" or potential
growth rate - the rate consistent with full employment and
quiescent inflation - will be about 2.5 per cent a year over
the next couple of years, the strongest since before the
It forecasts actual growth to run at 3 per cent next year
before easing back to 2.3 per cent the year after as interest
rates climb around 2 percentage points.
The drivers of that growth all come with some downside.
The cost of rebuilding and repairing large swathes of our
second-largest city is estimated to be $40 billion, nearly
half of which falls to overseas reinsurers.
It is a lot of work, not only for the construction sector but
for manufacturing - the Reserve Bank reckons a 1 per cent
increase in construction activity requires nearly a 0.4 per
cent increase in manufacturing - and sundry service
industries. But in the end all that investment is largely
replacing wealth destroyed three years ago, not expanding the
And the bank will be watchful for signs - not evident yet -
that rising construction costs will be the harbinger of wider
inflation, as in the past.
The renewed house price inflation, running at an annual 15
per cent in Auckland and nearly 10 per cent nationwide, has a
starting point of house prices and household debt levels
already very high by historical standards relative to the
incomes out of which mortgages have to be paid.
The glass-half-full view is that gravity will soon assert
itself and this housing cycle will prove less extreme than
the last one.
The glass-half-empty view is that a bubble mentality is
taking hold, inviting the sort of grief the United States,
Ireland and Spain have experienced in recent years when their
property bubbles burst all over them.
The OECD estimates the house price-to-income ratio is 26 per
cent above its long-term average, compared with 5 per cent
below the long-term average for the OECD as a whole.
A key question for next year will therefore be how effective
in mitigating that risk the Reserve Bank's experiment with
regulating loan-to-value ratios, combined with rising
interest rates, will be.
In addition to posing a risk to financial stability, house
price inflation is liable to spill over, via the wealth
effect and debt-fuelled consumption, into general inflation
as it did in the 2000s.
Already household saving rates, which went in the black after
the recession, have slipped back into negative territory with
households spending more than their income.
Meanwhile the net flow of migrants has flipped from a net
outflow in 2012 to a net gain of 20,000 in the year ended
November. Annualised, the gain for the past six months is
However, this has been driven by an economic slowdown in
Australia, our second-largest trading partner.
It will boost both the demand and supply sides, but the
demand side first, especially in the housing market.
It is not just the Australian economy that New Zealand is out
of sync with. We are expected to have one of the strongest
growth rates among developed countries over the next couple
And even though New Zealand's growth rate should continue to
be broadly similar to that of the United States, the latter
is arguably off a significantly lower base as measured by the
proportion of working-age people who are employed.
So, while the US Federal Reserve announced last week that it
intends to start scaling its bond purchases from the $1
trillion a year pace it has been running at, its forward
guidance on interest rates remains very dovish.
The differential between New Zealand and US shorter-term
rates can therefore be expected to widen as the Reserve Bank
embarks on a tightening cycle next year, probably in March,
which offers little prospect of relief from that quarter from
an overvalued exchange rate.
Arguably more important for the exchange rate is the terms of
trade - a measure of export prices relative to import prices
- which is at its most favourable for 40 years, reflecting
strong prices for exports. Historically rises and falls in
the terms of trade explain most of the exchange rate's
deviation from its long-term trend.
A high terms of trade boosts national income and the
associated boost to the exchange rate ensures the benefits
flow not only to farmers enjoying higher prices but to
consumers by way of cheaper imports.
But even with the best terms of trade for 40 years the
country has not been able to manage a trade surplus, though
the deficit is narrowing.
The rebalancing of the economy from growth driven by domestic
consumption to export-led growth, and to less reliance on
importing the savings of foreigners to fund investment, has
made some progress.
Finance Minister Bill English said last week that since
mid-2009, the trough of the recession, the tradable sector
has grown by around 11 per cent after stagnating between 2005
and 2009, while the non-tradable sector had grown by 6 per
Continuing that rebalancing required ongoing fiscal prudence
and microeconomic reform, he said. A lower exchange would
Of the six recessions since the mid-1950s, 2008/09 was the
second-worst in duration and severity, exceeded only by the
one that followed the first oil shock in the mid-1970s.
The recovery has also been the second-slowest. It has
nevertheless seen unemployment fall from a peak of 7.2 per
cent in September last year to 6.2 per cent a year later.
- By Brian Fallow, New Zealand Herald economics editor