Some thoughts on New Zealand's
Economic Expansion
A speech delivered to Development West Coast in Greymouth
On 8 December 2016
By Graeme Wheeler, Governor
2 The Terrace, PO Box 2498, Wellington 6140, New Zealand
Telephone 64 4 472 2029 Online at www.rbnz.govt.nz
Some thoughts on New Zealand's Economic Expansion
1. Introduction
Thank you for inviting me to meet with you again. It's always a pleasure to be
here and exchange views on how the economy is performing.
In many respects the economy is performing well. Relative to the trends over
the past two decades, we are experiencing stronger economic growth, lower
inflation, and a lower unemployment rate - even with record levels of labour
force participation. And the Achilles heel of many New Zealand expansions -
a large current account deficit - has not eventuated (figure 1).
Figure 1: Summary Macro-economic Indicators relative to trend
Source: Statistics New Zealand
Economists are well known for their two-handed assessments, and it won't
surprise you if I mention that not everything is as positive. The overall
expansion, now entering its eighth year, is weaker than other post-WWII
expansions. GDP growth on a per capita basis has been slow and labour
productivity growth has been disappointing. House price inflation is much
higher than desirable and poses concerns for financial stability, and the
exchange rate is higher than the economic fundamentals would suggest is
appropriate.
New Zealand is not alone in encountering these challenges. Most of the advanced
economies and several emerging market economies are experiencing weaker than
normal expansions and slow labour productivity growth. Several are experiencing
high house price inflation. In a world of weak trade growth and rising protectionism,
many would prefer to have a more competitive exchange rate.
I will return to some of these issues in discussing:
•
some of the characteristics of the current expansion,
•
the prospects for continued expansion and the key economic risks we
face, and
•
the role that monetary policy can play going forward.
2. Characteristics of New Zealand's Current Economic Expansion
i) The expansion has taken place in a difficult global economic
climate
Global economic growth in 2015 and 2016 is around 3 percent - the
weakest since 2009 and below its long-term average of 33⁄4 percent,
despite unprecedented global monetary stimulus and a major decline in
oil prices. Global trade, normally a catalyst for the global economy,
remains weak. Merchandise trade growth over the past five years has
been the slowest since the early 1980s, and protectionist measures in
G20 countries and elsewhere are on the rise. Economies are grappling
with the spillovers from unconventional monetary policies and
heightened political uncertainty has also been making households and
businesses more cautious.
ii) The current expansion is longer, but also weaker than previous
expansions
At 28 quarters, the current economic expansion is the second longest in the
past 40 years. Annual real GDP growth has averaged 21⁄2 percent during the
expansion, making it the weakest expansion during that time. Over the past
year however, annualised GDP growth has accelerated to a little over 31⁄2
percent (figure 2).
Figure 2: Real GDP growth over New Zealand business cycles
Index
Recession GDP (log levels, indexed Mar2010=100)
102
39 quarters at 0.91%
quarterly growth
100
28 quarters (to date)
at 0.62% quarterly
growth
98
24 quarters at 0.99%
quarterly growth
18 quarters at
0.74% quarterly
growth
96
18 quarters at
0.71% quarterly
growth
94
92
1976 1980 1984 1988 1992 1996 2000 2004 2008 2012
Source: Statistics New Zealand, RBNZ. Recessions are defined as two or more
consecutive quarters of negative quarterly growth.
iii) The drivers of the expansion have changed
Initially the expansion was driven by improving terms of trade (which
improved steadily from September 2009 and reached a 40-year high in June
2014), growing trade with China under the Free Trade Agreement, and the
stimulus from the 575 basis point decline in the official cash rate (OCR)
between mid-2008 and mid-2009.
Increased construction investment, initially linked to Canterbury earthquake
reconstruction, and the strong surge in migration and tourism have offset the
effects of the 8 percent fall in the terms of trade since mid-2014 and
contractionary fiscal policy since 2012. Monetary policy continues to be
accommodative with the OCR remaining well below the estimated neutral
interest rate, which is currently just below 4 percent.
These factors continue to be the main drivers of the expansion, although
Canterbury reconstruction is no longer a contributing factor.
iv) Record migration, record tourism, and historically high labour
force participation
In annual terms, net immigration has been the strongest since 1860. Net
permanent and long-term migration of 172,000 working age people has
increased the labour supply by 5 percent since 2012. Annual potential GDP
growth has more than doubled to around 2.9 percent from its 2010 trough of
1.2 percent, primarily because of this labour force expansion.
Private consumption is being boosted by the strong growth in migration,
record tourist inflows and the 111⁄4 percent increase in employment over the
past 3 years. At 70.1 percent, the labour force participation rate is at an all-
time high and the second highest among the advanced economies after
Iceland.
v) Labour productivity growth has been particularly weak
New Zealand's trend rate of labour productivity growth is in the bottom third of
OECD countries. There are many reasons for this including: distance from
markets; size of the domestic market; small size of most New Zealand firms;
limited participation in global value chains; and lower volumes of capital per
worker. But, as with most of the advanced economies, labour productivity
growth has been below its historical trend in the current expansion.
In the advanced economies, the decline in labour productivity growth is due to
a slowdown in the growth of investment per hour worked (reduced capital
deepening) and lower total factor productivity growth (TFP).1 In New
Zealand, the slowdown in labour productivity growth is mainly due to the
reduced contribution from TFP - the average contribution of TFP to potential
output growth in the current cycle has been less than half that of the previous
two cycles (figure 3 - TFP is a measure of how efficiently and intensively
other factors of production are being utilised).
Figure 3: Contribution to annual potential GDP growth in recent business
cycles
% %
4.5 4.5
1991-97 cycle 1998-07 cycle Current cycle
4.0 4.0
3.5 3.5
3.0 3.0
Total factor
productivity
2.5 2.5
2.0 2.0
1.5 1.5
Labour
1.0 1.0
Capital
0.5 0.5
0.0 0.0
1991 1995 1999 2003 2007 2011 2015
Source: RBNZ estimates
vi) The economic impact of high migration has been different from
earlier cycles
Migration inflows affect aggregate demand and supply in the economy.
In earlier cycles the short-term demand impacts (in terms of spending
and inflationary pressures) tended to dominate the effect of increased
labour supply in raising potential output in the economy. Earlier
periods of sizeable migration inflows, such as 2001-3, were quite
quickly reflected in capacity and price pressures, and a strong pick-up
in house price inflation.
House price inflation has been accentuated by the strong migration
inflows in the current cycle, but the impact on consumer price inflation
has been weaker than anticipated. This more muted impact on
spending is likely due to the higher proportion of younger cohorts in the
migrant flows, and the fact that many migrants are returning from a
weaker labour market in Australia and may be more cautious in their
3
spending.2
vii) The impact of wealth effects on private consumption has been
weaker in the current cycle
Growth in real consumption per capita has averaged 1.6 percent pa in
the current economic cycle - about 1⁄2 percentage point below the post-
1993 average growth rate of 2.1 percent, despite the rapid increase in
housing wealth. Although there are recent indications that per capita
consumption is increasing, the lower propensity to consume out of
household wealth and the increase in household saving have
contributed to weaker than expected inflation. This more cautious
consumer behaviour may reflect a reassessment of the 'permanency'
of capital gains from household assets, and greater caution about the
level and durability of future income growth.4
viii) New Zealand's terms of trade and the real exchange rate have
been higher in this cycle
Global commodity prices were on a downward trend from early 2012
and fell sharply after mid-2014. They began to pick up early this year.
New Zealand's terms of trade began falling in the second half of 2014,
but the real effective exchange rate has generally remained high
reflecting New Zealand's higher economic growth and interest rates
and the positive investment climate here compared to many other
advanced economies. Figure 4 shows the average real effective
exchange rate and average terms of trade during the past three
domestic expansions.
Figure 4: New Zealand's Terms of Trade and Real Exchange Rate
Index Index
85 1600
80
Real TWI
1400
75
70
1200
65
Terms of trade
(RHS) 1000
60
55
800
50
45 600
1989 1992 1995 1998 2001 2004 2007 2010 2013 2016
Source: Statistics New Zealand, RBNZ estimates. The real effective exchange rate is
a measure of competitiveness that adjusts the nominal effective exchange rate by
correcting for differences in relative inflation rates (or relative unit labour costs)
between New Zealand and its major trading partners.
ix) The recovery in household savings is reflected in an improved
current account position and lower external debt ratios
New Zealand's household net savings rate improved by 8 percentage points
in the period 2008 to 2013 (from minus 6 percent to positive 2 percent of
household disposable income (figure 5)). Over this period, New Zealand's
overall savings rate (ie including savings by the business and public sectors)
increased by around 5 percentage points, and this has been an important
factor behind the improvement in New Zealand's ongoing current account
deficit and the decline in net external liabilities as a share of GDP (this ratio
has declined from 84 percent of GDP in 2009 to around 63 percent of GDP
currently).
Figure 5: Household net saving rate (percent of disposable income)
% %
8 8
6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8
1987 1991 1995 1999 2003 2007 2011 2015-8
Source: Statistics New Zealand
x) The period of negative tradables inflation has been very long
Over the past five years, annual CPI inflation has averaged 1.1 percent.
During this period, inflation in the tradables sector (those industries exposed
to international competition) has been negative - averaging minus 0.8 percent
annually, compared to positive 1.2 percent in the prior two decades. This
means that pricing outcomes in the tradables sector have been a drag on
inflation, lowering annual CPI inflation, on average, by around 0.4 percent
(figure 6).
While relative prices continuously adjust to market forces, New Zealand is
unlikely to have experienced such a prolonged period of falling tradables
inflation since the Great Depression. Declining tradables prices reflect the
combined impact of the global over-supply of manufactured and capital
goods, falling technology costs, weak commodity prices, and the appreciation
in the New Zealand dollar exchange rate.
Figure 6: Traded goods inflation has been negative for five years
CPI Inflation and components
(annual)
% %
8 8
Projection
6 6
4 4
Non-tradables
2 2
0 0
Headline
-2 -2
Tradables
-4 -4
2005 2007 2009 2011 2013 2015 2017 2019
Source: Statistics New Zealand, RBNZ
xi) Long-run inflation expectations have remained anchored at 2
percent
A positive feature of the current expansion is how longer-term inflation
expectations have remained well-anchored at the mid-point of the Reserve
Bank's target range (figure 7). This is despite low headline inflation that has
pulled down short-term inflation expectations, and some evidence that
inflation expectations respond to past inflation outcomes more than before the
GFC (ie, they have become more adaptive and less forward-looking).5
Figure 7: Inflation Expectations Curve (annual, by number of years)6
% %
4 4
3 3
2 2
1 1
0 0
1 2 3 4 5 6 7 8 9 10
Source: RBNZ
3. Prospects for Continued Economic Expansion
In the absence of major unanticipated shocks, prospects look good for continued
strong growth over the next 18 months, driven by construction spending, continued
migration, tourist flows, and accommodative monetary policy. Our November 2016
MPS forecasts show annual real GDP growth of around 33⁄4 percent over the next 18
months, with inflation approaching the mid-point of the target band, the
unemployment rate continuing to decline, and the current account deficit remaining
within manageable levels.
Historically, expansions in small open advanced economies come to an end due to
one or more factors:
•
global economic growth weakens or slows in major trading partners and
affects the terms of trade and export growth;
•
a major domestic policy correction is needed to address a deteriorating
fiscal or current account deficit;
•
long-term interest rates rise significantly in response to offshore
movements triggered by higher inflation expectations and/or increased risk
premia in major economies. Alternatively, domestic short-term rates may
need to rise sharply to moderate inflation pressures associated with
growing supply and demand imbalances.
The main risks to the current expansion lie with future developments in the global
economy, and a deterioration in the imbalances in the domestic housing market.
i) Global risks
On the downside, the main risks are:
•
the Euro-area economy remains subdued or deteriorates, with
consumer and business confidence affected by developments relating to
Brexit, migration and anti-globalisation sentiment;
•
the incoming US Administration follows through on pre-election
rhetoric relating to trade barriers, and abandons or renegotiates
existing trade agreements;
•
economic growth in China slows following a period of financial
disruption linked to the very rapid build-up in corporate (mainly SOE)
debt over the past 7 years, and a rising level of bad debts in the formal
and shadow banking sectors.
The main upside risk is that the US economy in 2017 grows more rapidly than the 2 -
21⁄4 percent growth currently projected by the IMF, OECD and BIS, due to substantial
personal and corporate tax cuts and a large increase in infrastructure spending (with
no major moves to raise trade barriers).
ii) Risks in the domestic housing market
Numerous measures indicate that New Zealand house prices are significantly inflated
relative to usual valuation indicators.
IMF data show that New Zealand had the third highest real increase in house prices
among 64 countries in the year to June 2016.7 New Zealand also had the greatest
deterioration in the median house price to median income ratio of 31 advanced
countries in the period 2010 to mid-2016.8 OECD data indicates that, relative to their
long-term averages, New Zealand has the highest house-price-to-rent ratio, and the
second highest house-price-to-income ratio among the OECD economies.9
Several cross-country studies have assessed the economic implications of housing
market downturns. This research tends to show that almost half of the housing
booms end in a bust, with downturns lasting around four to six years10. In addition,
soft landings in the residential investment cycle are rare, with most collapses leading
to protracted falls in private consumption and investment, especially construction
investment.11
Even though it is too early to be sure, there are some indications that house price
inflation in Auckland and other regions may be moderating. This may be a result of
the increase in loan-to-value restrictions, higher funding costs being experienced by
banks, and tighter credit criteria being applied by banks in connection with financing
apartment development and house purchases by offshore residents.
4. Monetary Policy Considerations
We enter 2017 with considerable political and economic uncertainties. These
include: the policies of the incoming US Administration - particularly in regard to
fiscal policy and trade policy; the UK Government's strategy in triggering Article 50
and how the European Community will respond; the build-up of corporate debt and
rising bad debts in the Chinese banking system; the nature of the future political and
economic relationships between the US, China, Japan and Russia; and the possible
outcome of important upcoming elections in Western Europe. Central banks monitor
these developments carefully, and their impact on business and consumer sentiment
and asset prices.
New Zealand's economy has been growing faster than potential output for five years,
and the Bank's forecasts suggest that we now have a small positive output gap.
Long-term inflation expectations remain well-anchored at around 2 percent and short-
term inflation expectations have been rising slowly. The low point for CPI inflation
has probably passed and, supported by the improvement in global commodity prices
in recent months, we expect the December quarter 2016 CPI data to confirm that
annual CPI inflation is moving back within the 1 to 3 percent target band.
The central interest rate projections contained in the November Monetary Policy
Statement (MPS) indicated that the OCR is likely to remain at its current level for
some time. These projections are highly conditional and based on a range of key
assumptions that relate to: trading partner GDP growth and inflation; developments in
oil and dairy prices; exchange rate adjustment; migration and house price inflation;
and judgements as to how the latter two factors might affect spending and CPI
inflation. Different outcomes from those assumed in the MPS could imply a different
policy path. In the MPS we assessed the overall balance of risks to be on the
downside.
Since the US election there have been important global and domestic developments.
Ten-year bond yields in the US have risen by 50 basis points and the US real
effective exchange rate has appreciated by almost 5 percent and reached a 14-year
high as financial markets assess the implications of a possible large fiscal stimulus
for economic growth, inflation and the level of outstanding US government debt.
Ten-year government bond yields have increased by 40 basis points in New Zealand
(figure 8).
Figure 8: 10 Year Government bond yields
% Bps
4.5 250
Differential (RHS)
NZ
4.0
US
200
3.5
3.0
150
2.5
2.0
100
1.5
1.0
50
0.5
0.0 0
Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16
Source: Bloomberg, RBNZ
The factors behind the rise in US rates have increased market expectations that the
Federal Reserve will raise policy rates at its meeting on 13-14 December 2016, and
tighten more rapidly in 2017.
Prospects of stronger growth in the US and the resulting spillovers through trade,
commodity prices and relative exchange rate movements should be positive for New
Zealand and a welcome development from a monetary policy perspective. However,
while the 5 percent appreciation in the US dollar in recent weeks is helpful for New
Zealand exporters, the TWI currently lies above its level in June 2015, despite the
terms of trade being 6 percent lower and seven reductions in the OCR.
As has been the case in several other countries, monetary policy has been made
more challenging in New Zealand by low global inflation and zero or negative policy
rates in several major economies. This has put downward pressure on our interest
rate structure and contributed to asset price inflation and upward pressure on the
New Zealand dollar. This trend may finally be turning.
Another major change is the 7.8 strength Kaikoura earthquake. Early indicators are
that reconstruction work, including by government, could be in the order of $3 - $8
billion, or around 1-3 percent of GDP. This is much smaller than the $40 billion
associated with Canterbury reconstruction, and would occur at a time when the
domestic economy is at or near full capacity. The supply disruptions are unlikely to
have a major impact on overall economic growth. Some increase in construction
cost inflation is likely as this is already running at 7.9 percent in Auckland and 6.3
percent nationally due to capacity bottlenecks within the sector. Increases in freight
costs are also expected.
At this stage these developments do not cause us to change our view on the
direction of monetary policy as outlined in the November MPS. We expect monetary
policy to continue to be accommodative, and that the projected policy settings will
help generate sufficient growth to have inflation settle near the middle of the target
range.
5. Conclusion
Expansions in small open advanced economies often come to an end because of
developments in the global economy that are transmitted through the terms of trade,
long-term interest rates and the exchange rate.
At this stage, the prospects for a continuation of New Zealand's economic expansion
with above-trend growth, strong employment and rising inflationary pressures look
promising. The main domestic risk (and one that could be triggered by developments
offshore) is a significant correction in the housing market. At this stage, however, the
greatest threat to the expansion lies in possible international political and economic
developments and their implications for the global trading environment.
1
Furman, J (2015) 'Productivity Growth in the Advanced Economies: The Past, the Present,
and Lessons for the Future'. Remarks delivered to the Peterson Institute of International
Economies, July 9, 2015.
2
Vehbi, T (2016) 'The macroeconomic impact of the age composition of migration', RBNZ
analytical note, AN2016/03.
3
Armstrong, J and McDonald, C (2016) 'Why the drivers of migration matter for the labour
market'. RBNZ analytical note AN2016/02.
4
Bascand, G (2016) 'Changing Dynamics in Household Behaviour: What do they mean for
Inflationary Pressures?' Sir Leslie Melville Lecture: A speech delivered to Australian National
University in Canberra, Australia, 22 November, 2016
5
Karagediki, O and McDermott J (2016) Inflation expectations and low inflation in New
Zealand', RBNZ discussion paper, DP 2016/09.
6
Lewis, M (2016) 'Inflation Expectations Curve: a tool for monitoring inflation expectations',
RBNZ analytical note, AN2016/01.
7
IMF, November 2016 'Global Housing Watch'.
8
IMF, November 2016 'Global Housing Watch'.
9
OECD, 2016 'Focus on House Prices', and Global Economic Outlook, June 2016.
10
Bordo, M and Jeanne, O (2002) 'Monetary Policy and Asset Prices : Does Benign Neglect
make Sense', IMF working paper WP/02/223, IMF World Economic Outlook 2003.
11
Reinhart, C and Rogoff, K (2008) 'This Time is Different - Eight Centuries of Financial
Folly' (Princeton University Press). IMF World Economic Outlook 2003.