A smooth ride for the economy, but the road is getting steeper

By BRIAN FALLOW

The economy motors into the new year with much momentum but a gradually steepening road ahead.

Propelled by avid household consumption and a building boom, it clocked up a growth rate of 3.9 per cent in the year to September.

That is down from its peak of 4.5 per cent in the year to March, but higher than the 3.4 per cent average over the past 10 years and higher than the rate of around 3 per cent which it is thought the economy can sustain without inflation becoming a problem.

Household incomes have been stoked by the tightest labour market for 16 years, and a housing boom kept builders working flat out, boosted demand for consumer durables and provided a further fillip to consumer spending by way of the wealth effect - where people see their wealth rising from higher property prices and spend some of that increase, even if they have to borrow to do it.

Economists expect growth to continue slowing, to around 2.7 per cent, over the year ahead for three main reasons - migration, the exchange rate and monetary policy.

The inflow of migrants has been one of the main drivers of growth over the past year or more.

The combined effect of immigration, expatriates returning and a reduced outflow of New Zealanders pushed the population gain from migration to more than 42,000 (or more than 1 per cent of the population) by the middle of the year.

But it has been declining since, and is expected to continue falling as a recovering world economy provides greener pastures.

The Treasury assumes the net migration gain will have fallen to around 10,000 a year by 2006.

The importance of population growth, largely from migration, in keeping the economy humming is evident from the gap between overall economic growth of 3.9 per cent in the year to September and the per capita growth rate of 2.1 per cent.

But even with the labour force swollen by net immigration the demand for labour grew fast enough this year to reduce unemployment to 4.4 per cent, its lowest since 1987.

Also providing a braking effect on growth in the year ahead will be the relentless rise in the exchange rate over the past year.

Even though the steep appreciation against the United States dollar has been offset by a decline against the Australian dollar, on a trade-weighted basis the kiwi over the past month has been 12 per cent higher than a year ago and 30 per cent up on two years ago.

As a result, and despite a recovery in world prices, export commodity prices in New Zealand dollar terms are nearly 30 per cent under their highs of 18 months ago.

One of the puzzles of the past year is why this has not retarded the economy more than it has.

The Treasury says it is partly because it can take up to two years for exchange rate developments to affect export volumes and flow through to the rest of the economy.

It expects the rise in the exchange rate to have its greatest negative effect on economic activity from late this year.

But what about last year's appreciation? Why has there not been more of a slowdown?

Farm incomes fell 27 per cent in the year to last March, and further falls are expected, but that has not affected spending in the provincial areas.

The Bank of New Zealand's head of market economics, Stephen Toplis, put this down to the fact that rural land prices have not fallen in this downturn as they have in the past. That has kept farm balance sheets strong and has meant farm spending has been buoyed by the same sort of wealth effect evident in the suburbs.

In any case, not all New Zealand's exports are agricultural, and manufacturers, whose main export market is Australia, have benefited from the fall in the exchange rate against the Aussie dollar over the past year.

Australia is likely to grow faster this year than New Zealand - reversing the position over the past year - so ANZ economists expect the NZ dollar to slip to 83Ac by the end of this year.

The third factor likely to slow the economy next year is interest rates increases.

Reserve Bank Governor Alan Bollard has been indicating since October that he is likely to start raising rates, perhaps as soon as January 29.

At this stage, he is not expected to go much beyond taking back the "insurance" cuts of three-quarters of a percentage point made between April and July because of of uncertainties about the Iraq war, the Sars virus and the electricity supply.

Reversing those cuts would only return monetary policy to a neutral setting - neither stimulating the economy nor constraining it.

He is able to go easy on interest rates because the dollar is doing his job for him - pulling economic growth back into a zone sustainable from an inflation-targeting central bank's point of view.


But Toplis warns of the potential for a "nasty confluence" of factors making 2005 the danger year.

"This is the scenario: the soaring New Zealand dollar finally begins to bite. This is accompanied by the lagged effect of the cash rate increases we expect for early 2004.

"At the same time net migration flows turn negative and the housing and land price euphoria busts at the same time as the surge in global growth comes to an end."

The good news, says Toplis, is that if things go awry, policymakers have plenty of ammunition.

The Reserve Bank has ample scope to lower interest rates, and the Government's plump operating surpluses give it plenty of room to hit the fiscal accelerator.