KEY POINTS:
Economists are picking 2007 will be another year of below-par growth with the economy growing about half a per cent a quarter as it has over the past two years - better than nothing, but not much more than half its average rate over the past 10 years.
Governor Alan Bollard raised his official cash rate nine times over 2004 and 2005 and held it at what is by international standards a very high 7.25 per cent all last year.
But signs of renewed strength in retail spending and the housing market have raised the odds that he will hit the brakes again with another round of tightening.
The problem is that those brakes have been much more effective on the exchange rate side of the vehicle than the mortgage rate side.
The economy remains off balance, with growth concentrated in the inward-facing domestic spending parts of the economy, like the housing market, rather than the export sector.
That's just not sustainable. The so-called "soft landing" was too soft.
Inflationary pressures still need to be vented, household balance sheets need to rebuild. The evidence of an economy badly out of kilter is clear, in persistently high non-tradeable inflation, in the yawning chasm of a current account deficit, and in gravity-defying house price rises.
Inflation is running at 4 per cent in the non-tradeables side of the economy, where prices are unaffected by the exchange rate and not disciplined by international competition.
It has been at or above that level for two solid years. It is moderating slowly but much too slowly for the comfort of the Reserve Bank.
The Treasury does not expect to see non-tradeables inflation back below 3 per cent until late next year.
Overall consumer price inflation has dropped to 3.5 per cent and is expected to drop further in the short term, to perhaps 2 per cent by mid-year, reflecting a drop in international oil prices. But that is a temporary influence. It might even be reversed, hostage as the oil price is to all sorts of geopolitical factors.
The other thing keeping tradeables inflation low - the high kiwi dollar which makes imports cheap - comes at a stiff price for exporters and firms competing with imports.
The country's external accounts are also in a bad way. In the year ended October imports exceeded exports by $6.4 billion, representing $1.19 of imports for every $1 of exports.
Yet we need to run a small trade surplus to stop the deficit in the current account of the balance of payments from growing faster than the economy does.
The deficit is $14.4 billion or 9.1 per cent of GDP - better than in the June quarter but still very high by international standards. A corresponding inflow of foreign capital is needed to fund the deficit.
The cost of servicing the foreign claims on the New Zealand economy which have built up over decades of current account deficits is now equivalent to the economy's entire output every February.
Dependent on the kindness of foreign savers and investors
This degree of reliance on foreign savers and investors keeps interest rates systematically higher than they might otherwise be and leaves the country vulnerable to a change of sentiment on their part.
Bank of New Zealand chief economist Tony Alexander finds a degree of nervousness among exporters over the high New Zealand dollar and the absence of any sign that it is going to fall substantially any time soon.
"However, we are not finding major doom and gloom among exporters because of acceptable growth among our trading partners which will help tourism and high commodity prices which will limit the ongoing pullback in farm spending."
Manufacturing exports are underpinned by reasonable growth in Australia, by the kiwi/aussie exchange rate being just 5c above its long-term average and by productivity enhancements which appear to have raised the exchange rate which manufacturers can stand, Alexander says.
The basket of export commodities which ANZ monitors is at 20-year highs in world price terms, providing an offset to the high exchange rate for the primary sector. When translated into New Zealand dollars the ANZ commodity index is off its mid-2006 highs but still at historically high levels.
Just before Christmas, Fonterra reaffirmed its forecast for the current season of $4.05/kg for milk solids, down from $4.10 last season.
The meat schedule was heading south as 2006 ended.
Because higher commodity prices tend to be swiftly capitalised into higher land prices as well as lumpy capital spending, the effects of a fall in farmers' cash flow tend to be felt quite quickly in rural towns then, after a lag, in the main centres.
Dollar's bungy act masks declining trend
The dollar's bungy-like rebound against the United States dollar in the latter part of last year has masked its declining trend on a trade-weighted basis. The trade-weighted index's average value in the second half of 2006 was the lowest for three years.
Against the Australian dollar - its most liquid cross-rate and the one that matters most for manufacturers - the kiwi fell 7.5 per cent over the year.
But exporting manufacturers, like other businesses, had other things than the exchange rate to worry about.
With memories fresh of acute shortages of skilled labour firms have been wary of reducing staff numbers, as they would have in previous downturns, for fear that they might not be able to replace them when business picks up.
The continuing tightness of the labour market pushed wage inflation to cyclical highs last year and combined with higher energy and freight costs to squeeze profits at least on those sectors where competition is a constraint.
The results are clear in the tax data. In the four months ended October, the PAYE tax take was up 6.5 per cent on the same period a year earlier, but company tax was only 1.1 per cent higher.
However, skill shortages have become less of a constraint over the past year or so. Business surveys record firms' perceptions of the difficulty of finding skilled staff at the lowest level since 1999 and the proportion of firms saying it is the main constraint on lifting output is below the average for the past six years. But both indicators remain well above their average levels in the 1990s.
"We expect employment growth to be subdued," says Westpac economist Nick Tuffley. "It's not a matter of people getting laid off left, right and centre. It's the fresh hiring where the slowdown is likely to be more concentrated."
The consensus among economists is that the unemployment rate - now 3.8 per cent - will rise this year but remain below 5 per cent.
Combined with a net inflow of immigrants to levels well above the long-term trend, that level of job security should continue to provide a solid underpinning to the housing market.
Economists point to measures of affordability, like the ratio of house prices to incomes, the ratio of household debt to incomes, debt servicing costs as a share of incomes and rental yields, all of which are very stretched by historical standards.
But they have been predicting a housing slowdown for years and it keeps not happening.
Bollard was clear last month that it is the housing market more than anything else that will determine whether he yanks the reins tighter again.
CRYSTAL BALL GAZING
Darren Gibbs, Deutsche bank chief economist:
"It looks like it is going to be a reasonably good year - if Dr Bollard sits on his hands. But I'm increasingly inclined to think he won't be able to. And if he does hike he will have to do it more than once.
"It's an economy that's not booming but neither is it purging any of its excesses. We could be looking at growth of 2.5 per cent.
"The currency will stay high as long as the domestic growth story remains strong. So while higher interest rates may push the dollar high, the sooner we see weaker economic data, the sooner we will have a sustainable fall in the currency."
Nick Tuffley, Westpac economist:
"The rebalancing we need is waiting on the exchange rate and the indications are we are going to have a strong start to the year. The Reserve Bank will remain very nervous for the first few months of the year, especially with the housing market holding up so well.
"We still expect overall consumer spending will be pretty muted. Once the housing market does eventually turn down consumer spending will be more related to people's incomes instead of levering off rising housing equity.
"Exporters' foreign exchange cover is relatively short. Some people are hurting now, but it does mean than when the exchange rate does fall, the price impacts flow through relatively quickly."
Tony Alexander, BNZ chief economist:
"The constraints on growth are a high exchange rate, above average interest rates, tight business margins and shortages of resources like labour. These constraints mean it is unreasonable to expect the economy's growth rate will rise that much in the next few years. Average growth of 2 per cent per annum looks likely.
"It's not as if the economy is messed up or the outlook is bad. So long as businesses don't count on big increases in sales or big rises in productivity they should be okay."
Cameron Bagrie, ANZ National Bank chief economist:
"The Reserve Bank needs to see a big slowdown in 2007 because they can see a big pump-priming Budget the following year.
"The idea that interest rates will be heading down by the end of the year is looking less plausible and the risk is high rates could be sustained through 2008.
"We are going to see a sustained slowdown - our forecast for growth in calendar 2007 is 1.5 per cent. The question is the composition."
