Increasing the time being, the increase in household debt was sustainable, he said. Continued low interest rates meant the proportion of household incomes spend on debt servicing had remained low.
The current account deficit was only 3.5% of gross domestic product and it was not expected to change much in the year ahead.
However, if interest rates did rise materially in the future, current house prices would start to look less supportable and debt levels would be harder to service. That could result in a marked deterioration in economic activity, he said.
Interest rates were not likely to rise for a long time and that might mean economic imbalances and associated risks had a longer time in which to build.
Even in the absence of interest rate increases, rising debt levels would challenge the strength of economic growth.
"Debt can't keep growing indefinitely. Borrowers will eventually need to repay lenders and the more they borrow now, the bigger the reduction in spending in future years.''
The reduction in households' financial buffers due to higher debt levels meant they were more vulnerable to unfavourable changes in economic or financial conditions, Mr Stephens said.
Unfavourable developments were likely to result in larger changes in economic activity than would otherwise be the case - a particular concern given the other factors likely to dampen growth in coming year.
"Putting it all together, we have concluded the latter part of this decade is likely to see sluggish GDP growth. This signals a challenging environment for policy makers.''
In his Economic Overview: Moments in time, Mr Stephens said that New Zealanders taking on debt to fund consumption spending during times of low interest rates had "super-charged'' the housing market.
House price inflation had accelerated throughout the country and many regions outside of Auckland and Canterbury had recorded double-digit rates of price growth inflation in the past year.
Low interest rates had also spurred a resurgence in Auckland house prices after the imposition of new lending restrictions and new tax policies last year meant prices briefly fell, he said.
Those restrictions were always going to have only a temporary effect but the speed at which prices had rebounded had been surprising.
The strong and widespread increases had prompted Westpac to make a substantial upward revision to its house price forecasts. A 10.5% increase in nationwide prices was expected this year, up from 6% previously.
As had historically been the case, strength in the housing market had meant New Zealanders went into borrow-and-spend mode. Homeowners tended to spend some of the windfall they perceived when the value of their house rose while aspiring buyers must borrow more. The net effect was an increase in both borrowing and spending, Mr Stephens said.
The debt-funded strengthening in the household sector was helping to offset the weakness in other parts of the economy, particularly the dairy sector. In that sense, increases in borrowing signalled monetary policy was working as expected.
The borrow-to-spend dynamic meant household debt levels climbing rapidly, he said. Since 2012, the amount of debt households were carrying had risen to levels equivalent to 162% of their annual disposable income.
That was higher than the peaks reached before the last financial crisis and had completely reversed the reduction in debt levels seen over the last few years.
