Economic sprint running out of puff

The economy may be about to enter heavier waters, Michael Cullen says. Picture / Greg Bowker

Economic growth over the next two years will be significantly weaker than was expected prior to the election just four months ago, the Treasury says.

"After growing 25 per cent since 1999 - against an OECD average of only 16 per cent - the economy may be about to enter heavier waters," Finance Minister Michael Cullen said yesterday, after the release of the Government's half-yearly economic and fiscal update.

The Treasury forecasts growth to slow to 1.7 per cent in the year to March 2007 and 2.5 per cent the year after. That is, respectively, 0.9 and 1 percentage points weaker than in the previous forecasts and the weakest consecutive years' growth since the Asian crisis in 1997.

Imbalances in the economy noted in earlier forecasts - rising inflation, a wide current account deficit and overvalued house prices - had only intensified, the Treasury said.

Since the pre-election forecasts, interest rates and the exchange rates have climbed as the Reserve Bank attempts to lean on rampant domestic demand.

"Part of the reason for continued strength in household spending has been related to the strong labour market, which has provided additional jobs as well as strong wage growth," the Treasury said.

"Low unemployment by historical standards is also likely to have buoyed consumers' confidence about job security and their ability to service increased debt levels in the future."

Even though the Reserve Bank had raised interest rates by 2.25 percentage points since the start of last year, the effect had been diluted by the availability of "relatively attractive" fixed-term mortgages. Household debt had swollen from 136 per cent of disposable income in 2003 to 158 per cent now.

Although that increase in debt had been more than matched by increases in house prices - so that households' net wealth has increased - the Treasury did not believe further gains in house prices could be sustained beyond the next six months.

So it expected to see a reduction in the wealth effect, where people boost spending by borrowing against an increase in the value of their houses.

It predicted household spending to be hit by other factors such as:

* Higher mortgage rates as the effects of previous rate hikes feed through.

* Fewer new jobs.

* Slower wage growth.

* Higher petrol prices, leaving less to spend on other things.

A key judgment underlying its forecasts related to how households responded to rising debt levels, the Treasury said.

"As the effect of higher debt servicing begins to impinge on household budgets, there is a risk of a bigger slowdown if households become more uncomfortable about their debt levels." This would be particularly so if rising unemployment makes people feel less secure. In that scenario a hard landing could be in store with growth slowing to 0.7 per cent by March 2007.

The Treasury forecast a gradual rise in the unemployment rate from a world-beating 3.4 per cent now to 4.5 per cent by 2010. Wages growth was forecast to remain above 4 per cent through next year, helping to underpin household incomes.

Its central forecast assumed the exchange rate would head back down towards its long-run average value over next year and 2007.

But it expected the current account balance of payments to get worse before it improved, expanding to $14.2 billion, or 9.1 per cent of gross domestic product, by March next year.

The farm sector's 2005-2006 season was expected to be affected by slightly adverse climatic conditions, delaying a recovery in export volumes.

As businesses' profitability comes under pressure they were expected to respond by cutting back on investment projects and hiring fewer workers.

The strong growth in employment was likely to have attracted less experienced and skilled people into the workforce, diluting labour productivity.

But as they became more experienced labour productivity was expected to improve again, boosted by the strong lift in business investment.