Graeme Wheeler: The building blocks of the economic expansion
Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the
Canterbury Employers' Chamber of Commerce, Christchurch, 31 January 2014.
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Introduction
Small open advanced economies like New Zealand tend to have economic cycles that are
heavily influenced by developments in the global economy. We saw this when our growth
rate slowed during the Asian financial crisis in the late 1990s and the collapse of the dot-com
bubble in the United States three years later, and, most recently, during the global financial
crisis (GFC).
Over the past two years our economy has outperformed most of the advanced economies.
Our growth rate has averaged 2.7 percent, or twice the average of the group of 35 advanced
economies in the IMF classification. Most of our economic indicators are positive with the
terms of trade at a 40-year high, business confidence is the strongest since 1993, and
consumer confidence is at a seven-year peak.
This afternoon, I would like to offer some thoughts on the reasons for our stronger economic
performance, and discuss the nature of the expansion and the challenges facing the Reserve
Bank in helping to ensure that the expansion can be sustained.
2008 - 2011: Four difficult years
Although New Zealand experienced a shallower recession than most of the advanced
economies during the GFC, the economy has faced many difficult adjustments in recent
years. These include: the liquidation of over 60 finance companies beginning in 2006 and
2007; the collapse of global trade in 2008 and 2009; droughts in 2008 and 2012; and the
devastating Canterbury earthquakes in 2010 and 2011.
The earthquakes, in particular, had a profound human and economic impact that will
continue to be felt for many years. On a global scale, the Canterbury earthquakes are among
the 10 costliest natural disasters in recent history. Relative to the size of the economy, the
earthquakes are the most severe natural disaster faced by an advanced economy in recent
times (table 1).1
In Canterbury, businesses closed, residents moved away, and foreign students and tourists
stopped coming. Businesses that exported or competed against imported goods and
services also faced the twin burdens of the high New Zealand exchange rate and more
aggressive pricing by foreign competitors as global trade volumes slowed.
In order to facilitate recovery in the economy, while maintaining the Reserve Bank's
obligations for price stability, we lowered the official cash rate to 2.5 percent, and helped to
generate the lowest retail interest rates in 60 years.
The forces behind New Zealand's economic recovery
Several factors beyond monetary accommodation contributed to New Zealand's economic
recovery. These include: the recently improved economic climate in advanced countries; high
export prices for our major commodities; the strength of construction investment, particularly
in Canterbury; and the range of other factors driving the increase in private consumption.
(i) The international economy
The global economy is recovering after many years of fragility and uncertainty. Output growth
has increased in recent months in several advanced and emerging countries. World trade
volumes are increasing and the global economy is now growing at about its average rate
over the past three decades - albeit with exceptional monetary stimulus from central banks
in the major economies. Business conditions have improved in the United States especially,
and in Japan and in the United Kingdom. The euro area has emerged from recession but the
recovery is slow and uneven. China, the world's second largest economy, is growing at
around 7.5 percent.
(ii) The high terms of trade
New Zealand's terms of trade are at their highest level since 1973 (figure 1).
Our farmers, especially, are enjoying very favourable export commodity prices and an
excellent season of grass growth. Considerable focus is on the extremely high international
dairy prices, but aside from aluminium, all of the sub-categories of the ANZ Commodity Price
Index are at or near record highs. Strength in the New Zealand dollar is distributing some of
these gains to the broader spending public, but, even accounting for this, export prices in
New Zealand dollar terms are well ahead of those received in the 2008 commodity price
boom.
New Zealand is benefiting considerably from its export linkages with the rapidly growing
economies of East Asia, especially China, and with Australia. Over the past decade China's
share of our exports has increased from 3 percent to 21 percent. China is now our largest
export market for all our agricultural commodities except beef, where it is second only to the
United States (figure 2).
(iii) The strength of construction investment
Over the past two years, construction investment has increased by 40 percent, largely due to
the Canterbury re-build. The cost of the Canterbury re-build is forecast to be around
NZ$40 billion in current prices, or around 20 percent of annual GDP. This massive
reconstruction is a unique feature of the New Zealand outlook. It will have a major impact on
the local and national economy for a number of years to come.
Although there is considerable uncertainty as to the magnitude and phasing of the re-build,
annual construction investment associated with the re-build is projected to peak in 2016 and
2017 at around $4 billion. In terms of its contribution to New Zealand's GDP growth,
reconstruction-related investment is expected to peak in 2014, with investment doubling
relative to 2013 (figure 3).
Construction activity is also increasing in Auckland. Residential consent issuance is running
at 6000 per year - double the rate of mid 2011 (figure 4). The Auckland Accord set a target
of 39,000 new housing consents over a three-year period and the Government, together with
the Auckland Council, recently designated special housing areas for fast-track resource and
building consent with capacity for 15,500 new homes.
If these targets for Auckland are met over the next three years, and if 12,000 new homes are
constructed in Christchurch, as predicted, then construction volumes would need to be
10 percent higher than in 2004, which represented the peak of the last building boom. This
estimate, however, assumes no growth in home building in the rest of the country. Pressures
on the construction industry will also increase with New Zealand's infrastructure needs and
repairs on the remaining 42,000 leaky buildings nationwide.
(iv) Growth in private consumption
Real private consumption has been growing at an annual rate of around 3.5 percent in 2013
as a result of many factors: the high terms of trade, the 40,000 person increase in
employment, the 20,000 person increase in permanent and long-term immigration, the
9.5 percent increase in house prices, strong consumer confidence and low real interest rates.
Private sector consumption and investment have driven the recovery and accounted for
much of New Zealand's economic growth over the past two years.
Can the economic expansion be sustained?
In small advanced open economies, expansions usually come to an end for one or more of
the following reasons: growth in the global economy slows; the nation's terms of trade
decline significantly; a major policy correction is needed to address a deteriorating fiscal or
current account deficit; or interest rates rise significantly in order to moderate rising inflation
pressures associated with growing supply and demand imbalances. The economic slowdown
is intensified if the adjustment is accompanied by a sizeable decline in house prices.
Are any of these factors likely to end New Zealand's current expansion?
A further slowdown in global growth remains possible given the vulnerabilities in several
major advanced economies due to low productivity growth and high levels of public and
private sector debt. The areas of greatest risk lie in a potential faltering of momentum in the
euro area, and the rapid build-up in debt levels in China, part of which originated in the
shadow banking sector. However, international financial institutions such as the IMF and
World Bank have recently increased their central forecasts for global growth and the
sentiment at the World Economic Forum in Davos earlier in the month was generally more
upbeat, despite market jitters around some emerging market economies.
Some reduction in the terms of trade might be expected in light of their high level and the
projected increase in world dairy supply. But any decline in export prices is likely to be
moderated by the improving outlook for global growth and world trade. The current account
deficit is expected to deteriorate with increased imports, but not to provoke a severe
adjustment. Nor are major changes in fiscal policy envisaged. The Treasury's forecasts
suggest that the fiscal outlook is for a small surplus in the 2014/15 financial year and
surpluses of around 2 percent of GDP in 2017/18.
An important risk to the expansion lies in the increase in inflation pressures, and the rise in
interest rates necessary to contain them. Annual consumer price inflation is currently
1.6 percent. As shown in figure 5, inflation in the tradables sector has been negative for the
past 21 months, mainly due to the high exchange rate, and intensive international
competition associated with the global oversupply of manufactured goods. Non-tradables
inflation is currently increasing at an annual rate of 2.9 percent and is expected to rise
towards 4 percent as the labour market tightens and capacity bottlenecks increase,
especially in the construction sector.
Some increase in inflation pressure is inevitable as the economy is growing more rapidly
than potential output.2 Potential output growth slowed in the recession of 2008/9 and has not
regained its pre-recessionary rate. We estimate that over the last two years potential output
has grown by a little over 2 percent annually, compared with average GDP growth of
2.7 percent. This gap between the actual growth rate and the potential growth rate increases
pricing pressures in the economy.
Some factors are constraining the recovery in potential output growth. While New Zealand's
labour force participation is close to its pre-recession peak and the unemployment rate is
falling, data suggests that skilled labour is becoming more difficult to find. The share of
investment in GDP fell sharply in the recession and is now only back to its pre-recession
level. Labour productivity only surpassed the pre-recession level in 2011 and OECD data
suggests that multifactor productivity fell during the recession and has been slow to recover.
Price pressures are particularly apparent in the construction sector as resources are
reallocated to Canterbury and Auckland from other regions and activities, and spare capacity
in the economy is being absorbed at a rapid rate. Such cost pressures could spill over into
broader consumer price inflation, particularly if the construction sector reaches capacity
constraints (employment in the sector is currently 9 percent below its 2006 peak). Household
debt is rising again and households are forecast to spend more than they earn in 2014.
Stronger inflation pressures and the increase in interest rates that would accompany them
could put pressure on New Zealand's real effective exchange rate and reduce the
competitiveness of our export and import-competing industries.3
Increases in the price of construction services in Canterbury are needed to attract resources
to the re-build, but a key issue is whether they are spilling over into other sectors and
regions. There are signs that this is starting to happen. Annual construction cost inflation in
Auckland and the rest of the country has risen steadily over the past 12 months and is
currently running at 5 percent (figure 6).
Inflation pressures may also intensify if there is a rapid fall in the exchange rate. Exchange
rate corrections can never be ruled out, especially when the exchange rate remains close to
historic highs on a TWI basis and in the top decile of historic experience against the major
currencies, including the Australian dollar. The New Zealand exchange rate has experienced
rapid and prolonged falls on several occasions over the past 30 years (figure 7).
The monetary policy response to a sudden correction in the exchange rate would depend
largely on what triggered it. An interest rate response might be warranted if it were driven, for
example, by portfolio investors reducing their exposure to New Zealand with few real
economic factors underpinning it. It may not be needed if the decline in the exchange rate
was driven by a sharp fall in the terms of trade.
A further risk to the expansion is the level of house prices. By historic and international
comparisons, New Zealand house prices are overvalued. A recent OECD study indicated
that house prices in relation to income are 25 percent above their long-term averages, while
rents are 60 percent above.4 The situation is exacerbated by household debt levels of around
150 percent of household disposable income that are again on a rising trajectory.
While a substantial fall in New Zealand house prices is unlikely, such a fall could happen if
there was a marked deterioration in the household sector's ability to service its mortgage
debt due to a sharp rise in unemployment, falling incomes, or very high domestic interest
rates. A sharp correction of the type seen in several advanced economies in recent years
would likely be accompanied by a domestic recession. The housing market poses risks to
financial stability and the broader economy, and is a major reason why the Reserve Bank
introduced speed limits on high loan-to-value ratios for residential mortgages in October
2013. At present, we have limited data relating to the post-LVR period. The information to
date suggests that housing turnover and the rate of house price inflation may be easing, but
this could be due either to LVR restrictions or other factors such as house affordability. It will
be some time before we can gauge the overall effect of the measures.
Monetary policy going forward
The Reserve Bank's goal under the policy targets agreement is to keep future average
inflation near the 2 percent target midpoint. Achieving this will help to ensure that economic
activity is kept more in line with the potential growth of the economy, thereby promoting a
more sustainable growth path.
Further, price stability itself has benefits for long-term economic growth. It enables
households, businesses, and governments to plan with greater certainty; it facilitates
longterm contracting; lowers the inflation risk premia embedded in interest rates; and enables
producers, consumers, and investors to respond to opportunities created by changing
relative prices rather than diverting resources to hedge against inflation. These benefits are
eroded when inflation and inflation expectations become excessive.
If actual inflation and expectations of future inflation were to rise significantly,
competitiveness and real income growth would decline. The Bank's subsequent efforts to
maintain price stability by raising nominal and real short term interest rates would be more
disruptive, the further inflation was allowed to deviate from target.
Assessing the timing and magnitude of increases in the OCR involves difficult judgements
because changes in interest rates tend to affect the rate of growth of output and inflation with
a 12 to 18 month time lag, although it can be more rapid if the main transmission effects
operate through the exchange rate. This means that interest rate judgements need to assess
the degree of inflationary pressure in the economy throughout the forecast period and how
inflation expectations and pricing behaviour might change in response to different levels of
the OCR. These are judgements we face all the time. The complexity of them is increased in
current circumstances by the fact that New Zealand's terms of trade are at a 40-year high;
our exchange rate remains close to historic highs on a TWI basis; the economy is
reallocating resources to meet construction needs in Christchurch and Auckland; rising
house price inflation is adding to consumer demand; net migration is increasing rapidly; and
the United States is cutting back the scale of its quantitative easing.
The Reserve Bank's approach in assessing interest rate responses is driven by a
combination of models, data, and judgement. We assess new economic information and
whether it is different from the assumptions built into our published economic forecasts and
interest rate projections. In the past six weeks for example, indicators on New Zealand's
economic growth and inflation have been stronger than those built into our December
projections, but the exchange rate has also been stronger and initial indications are that
house price inflation may be starting to moderate, although it is too soon to draw firm
conclusions. The exchange rate remains a considerable headwind for the economy, and the
Bank does not believe its current level is sustainable in the long run.
We will undertake a comprehensive assessment of the outlook in the next Monetary Policy
Statement in March when further information will be available.
The Reserve Bank's projected path of interest rate rises contained in the December
Monetary Policy Statement suggests that the OCR will need to rise by around 2 percentage
points over the next two years. Yesterday we kept the OCR unchanged at 2.5 percent, but
signalled that inflation pressures are rising and that interest rates will need to return to more
normal levels in order to keep future average inflation near the 2 percent target mid-point.
We also indicated that the scale and speed of the rise in the OCR will depend on future
economic indicators.
Conclusion
This afternoon, I have outlined the factors behind New Zealand's strong economic growth,
and the challenges facing the Reserve Bank in helping to ensure that the expansion can be
sustained.
We have supported the recovery through low policy rates. We recognise that the economy
has been growing faster than potential growth for some time. Although headline inflation has
been moderate, inflationary pressures are building and are expected to increase over the
next two years. In such an environment, there is a need to return interest rates to
morenormal levels and the Bank expects to begin this adjustment soon.
Achieving this will help to ensure economic activity is kept more in line with the potential
growth of the economy, thereby promoting a more sustainable expansion.