Bubbles waiting to be pricked

Consumers ended 2004 feeling the happiest they have for 10 years. Little wonder.

A buoyant economy created 56,000 new jobs in the year to September. Employment growth has made inroads into parts of the population often disadvantaged in the labour market: the long-term unemployed, the over-55s, women and Maori.

The unemployment rate of 3.8 per cent is the second-lowest among industrial countries and the lowest it has been in New Zealand for 18 years.

Add to that wage increases of about 3.5 per cent and you have a significant boost to household incomes.

The spending side of the economy was turbocharged by the "wealth effect" from housing.

Even though the rate of house price inflation (or capital gains, as owners prefer to think of it) peaked in late 2003, the value of the housing stock still rose by a sixth in the year ended September.

People have been prepared to borrow and spend some of that increase in wealth. Can this spree last?

For what it is worth, the economic forecasters think not.

True, they kept forecasting a downturn last year which never quite arrived. But the boy who cried wolf eventually was right.

Private consumption grew 6 per cent after inflation in the year to September, according to the national accounts released just before Christmas. The consensus among economic forecasters is that that will slow to 2.3 per cent by March next year.

The Treasury's reasons for expecting it to fall include slower growth in the population. Net immigration peaked in May 2003 and has been declining steadily ever since.

Another reason is the increase in the debt burden households face after the large increase in mortgage lending of the past few years.

Households owed the banks just under $100 billion at the end of October, up $12.6 billion or 14.4 per cent on a year earlier. The cost of servicing that debt looks set to rise. Reserve Bank Governor Alan Bollard raised the official cash rate six times last year, 1.5 percentage points in all, but by year's end the braking effect had hardly begun to be felt.

One of the main channels by which what the Reserve Bank does is supposed to flow through to the economy - mortgages - has been thoroughly clogged.

Increases in the official cash rate flowed through to higher floating mortgage rates quickly. By the end of October (the most recent official figures), the average floating mortgage rate was 8.2 per cent - up from 7 per cent at the start of the year.

But, unfortunately for Bollard, less than 30 per cent of mortgage debt is at floating rates. In the course of the year, the average interest rate being paid by people on fixed-rate loans increased only a little - 15 basis points for one-year loans and 29 basis points for two-year loans. That is not much to show for a 150 basis point tightening by the central bank.

Partly this is the normal lag; buying time before rising mortgage rates bite is the point of taking out a fixed loan, after all.

But it also reflects the fact that the banks could fund new fixed-rate loans from cheap international money and, towards the end of the year, they were embroiled in a margin-destroying war.

The banks have called a Christmas ceasefire in that war, lifting the rates for new loans to more commercial levels. If that holds, Bollard's rate hikes should bite into the spending power of households with mortgages this year.

And with many forecasters, including the Reserve Bank, expecting house prices to dip back 5 per cent or so by the end of the year, before levelling off, the extra spending fuelled by the wealth effect should wane as well.

At this stage, the financial markets believe interest rates are on hold most likely until the second half of the year and that the next move in rates will be down.

But Bollard's monetary policy statement last month said there was little scope for an easing "in the foreseeable future".

Even with the economy forecast to slow from a cracking 4.75 per cent pace in the year to next March to a plodding 2 per cent for the next two years, the bank still forecasts inflation to still nudge the top of its 1 per cent to 3 per cent target range.

Bollard said that left little headroom to absorb stronger-than-expected inflation pressures. If such pressures emerged, another tightening of the interest rate screws could not be ruled out.

Farmers' incomes, meanwhile, have been bolstered by the fact that even though the dollar has risen sharply during the past year, world prices for export commodities have risen even faster.

ANZ's world commodity price index in November was 17 per cent up on a year ago. Even when converted into New Zealand dollars, it was 6.4 per cent higher.

Dairy prices were at their highest since 1996, lamb prices the highest they have ever been in the 19-year history of the index, and beef prices still at historically high levels, though off their peak in September.

But with global economic growth expected to ease back to more normal levels, and some of special supply-side factors like drought in Australia unwinding, world prices for export commodities may well soften.

That would undermine an important source of buoyancy for the national income during the past two years, namely a 10 per cent improvement in the terms of trade. It measures the ratio of export to import prices - how many plasma TVs you can buy for a container-load of skimmed milk powder.

And not all exporters have had the buffer of higher commodity prices. Forest products exporters have felt the full icy blast of a higher exchange rate and higher freight costs as well.

Even with benign terms of trade, 2004 ended with news that the annual merchandise trade deficit had widened to $4.2 billion and the balance of payments deficit to $8.2 billion.

In theory, worsening external deficits, weaker domestic growth and a smaller gap between New Zealand and overseas interest rates will bring the dollar down from the icy heights it has reached.

The risk, as ever, is that it gets worse before it gets better.