Brian Fallow: Too soon to remove economy's bandages

The rebuilding of Christchurch could create a bottleneck in the construction industry. Photo / Brett Phibbs

When Bill English delivers his third Budget in three weeks' time, chances are it will contain some fairly upbeat forecasts about the economic outlook, for next year if not this one.

They will go something like this: Export commodity prices are up 30 per cent on a year ago and the terms of trade the best for 37 years, boosting national income.

Meanwhile, highly stimulatory monetary policy will work its magic, first on the housing market and then on consumer spending. The official cash rate is at an all-time low and the effective or average mortgage rate is 2 percentage points lower than it was before the recession.

Christchurch needs to be rebuilt and much of the cost will be borne by an inflow of reinsurance money. Broad sunlit uplands beckon.

If this proves to be the Treasury view it will not be eccentric. The consensus forecast among economists for annual average growth in the year to March 2013 is just under 4 per cent.

But forecasts are only as good as the assumptions underpinning them. There is always a risk that they are wrong and that risk is especially big right now.

Perhaps the biggest uncertainty is how much difference the legacy of debt from the last boom will make to the behaviour of households and farmers.

Policymakers have been rather taken aback by how completely we have got the message about excessive borrowing and spending.

The split between spending and saving has shifted in a more provident direction. We might even, for the first time in many years, be spending less than we earn. How durable a change this will prove to be is the question.

Until the answer is clear, forecasts based on past relationships are a rickety basis for aggressive policy.

A research project led by Professor Bob Buckle found that the biggest single influence on the New Zealand economic cycle is export prices.

So the fact that they are at record highs, even in New Zealand dollar terms with the exchange rate at its elevated level, is unambiguously good news.

But at the same time that farmers are enjoying those high prices, farm sales in the first three months of the year were at a 15-year low, according to the Real Estate Institute. Farmland prices have fallen about 25 per cent from their 2008 highs.

Farm-sector debt at the end of February was almost unchanged (up less than 1 per cent) on a year earlier, according to the Reserve Bank. By contrast, farm debt had almost quadrupled over the previous 10 years.

All this is pretty clear evidence of caution and a focus on repairing overstretched balance sheets.

So the question is how much of the income boost coming farmers' way from higher export prices will get soaked up by the parched earth of farm debt, and how much will flow to the rest of the economy?

The answer has to be, at this stage, who knows? It is a somewhat similar story with households.

There are tentative signs that the housing market in Auckland has turned the corner. The number of sales last month was 11 per cent up on the depressed levels of March last year and prices were nearly - wait for it - 2 per cent higher. Nationwide it was a different story, however.

Even with Canterbury backed out of the figures; turnover was up only 1 per cent and prices were 2 per cent lower than a year ago.

Meanwhile, consumer confidence is weak and household credit growth is weak, too, up just 1.5 per cent for the year. But the ratio of household debt to income remains extremely high by both historical and international standards.

After three years of newfound providence, the savings rate may have - just - turned positive. That should not be regarded as an aberration. It is the norm in comparable countries.

The labour market is weak. The unemployment rate is 6.8 per cent. Wage growth is generally the last cab off the rank in any economic upswing.

Higher food and oil prices, a global trend from which we are not immune, are pre-empting a larger share of incomes. And mortgage rates are not going to remain at these low levels indefinitely. The money market has priced in at least two and maybe three official cash rate hikes by this time next year.

All of which makes it hard to quarrel with ANZ chief economist Cameron Bagrie's conclusion that we can "rule the consumer out as a key driver of an economic recovery".

What then of the Canterbury rebuild? Westpac chief economist Dominick Stephens estimates the influx of money into Canterbury from overseas reinsurers and central government, earmarked for construction, will be akin to a fiscal stimulus package worth 60 per cent of the region's pre-quake gross domestic product.

"Less clear is just how quickly the rebuilding can take place. Our own forecasts have residential building activity peaking in late 2012, while the more involved non-residential building work isn't expected to peak until 2013."

But while there is plenty of spare capacity in the construction sector right now, that is partly because there has been a significant level of underbuilding in Auckland - by about 5000 dwellings a year, according to one estimate.

At some point that pent-up demand will have to be met, to say nothing of leaky homes still in need of repair and possibly some competition for tradesmen from flood-ravaged Queensland.

It is a recipe for bottlenecks, frustration and inflation.

Most forecasters expect it will be early next year before the Reserve Bank starts raising interest rates again. "But the hikes could be quite rapid once they start," Stephens says.

"Rising interest rates and the higher cost of construction will actually crimp consumption and investment outside of Christchurch. To some extent we will end up with a two-speed economy, where the growth is concentrated in a single region."

Despite these risks and uncertainties, the Government is apparently hell-bent on tightening fiscal policy through a "zero Budget", in which the normal allowance for new operating spending has been eliminated. In dollar terms, the impact on aggregate demand is about equal to raising interest rates by 50 basis points.

Imagine if Alan Bollard had raised the OCR to 3.5 per cent last month, citing the inflationary implications of the earthquake, instead of cutting it to 2.5 per cent as he did. There would have been howls of outrage.

How crazy, people would have said, to tighten policy when a shock of this magnitude has hit an economy that just isn't growing. It still is.

A fiscal tightening at this delicate stage of the cycle is premature and risky. The Government should wait until it is certain the bone has healed before taking off the plaster cast.