Reserve bank lifts growth 'speed limit'

McDermott says inflationary pressure are expected to increase. Photo / NZ Herald

Potential growth of the economy is expected to peak at 2.8% next year after more investment in productive capital

The Reserve Bank has revised up its estimate of the economy's potential or non-inflationary growth rate next year, but it is still shy of the levels prevailing between the mid-1990s and the mid-2000s.

It is commonplace to describe the potential output growth rate as the economy's "speed limit" - to convey the idea that it is possible but dangerous to exceed it.

However, the bank's assistant governor and chief economist, John McDermott, in a speech to the Wellington Chamber of Commerce, yesterday made it clear that it is much more variable and much less certain than that term would imply.

The bank's estimate of potential growth has increased since December and it is now expected to peak at 2.8 per cent next year rather than 2.5 per cent, he said.

The increase reflected data revisions which revealed there has been more investment in productive capital than previously thought; strong business confidence, which suggests future investment could be stronger than previously thought; and a surge in net immigration which means the supply of labour is expected to be stronger than previously expected.

"With the economy growing at a faster rate than potential output, inflationary pressures are expected to increase. In this environment, it is important that inflation expectations remain contained and that interest rates return to a more neutral level," McDermott said.

"Potential output is determined by the economy's productive base - that is the supply of labour and capital and the efficiency with which these factors are utilised."

They combined to deliver potential growth rates between 3 and 3.5 per cent between the mid-1990s and mid-2000s reflecting stronger growth in productivity and in the labour supply than the bank sees in the offing now. But following the 2008/09 recession the potential growth rate dropped to just 1.2 per cent.

It is challenging for forecasters to distinguish structural changes from cyclical effects.

McDermott gave the example of one component of the labour input part of the calculation of potential: the participation rate, which is the proportion of the working age population either working or actively seeking work.

Over time the participation rate has increased as more and more women joined or rejoined the workforce, and more recently as older New Zealanders kept working longer.

But labour force participation is also influenced by the state of the economic cycle, with upswings encouraging more people to actively seek work while recessions see discouraged workers exit the labour force, reducing the participation rate.

The bank expects the upward trend in the participation rate to continue for the rest of this decade, albeit more slowly than between the mid-1990s and the eve of the recession.

Ultimately, McDermott said, the quantity and quality of the productive inputs of labour and capital are largely determined by the choices individuals and businesses make - how much to work, how much to save and how much to invest.

"These preferences can be influenced, for good or for ill, by the policies of central Government," he said.

Monetary policy, on the other hand, cannot affect them in any enduring way.

"It can however provide a stable backdrop against which individuals and businesses can make decisions about the most efficient allocation of their resources."