Brian Fallow: Business survey gives reality check

If business wants the Reserve Bank to raise the speed limit it had better get investing. Photo / Dean Purcell

It is clear there will need to be a landing or two in the staircase of interest rate rises ahead.

The New Zealand Institute of Economic Research's quarterly survey of business opinion (QSBO) is a reality check about the strength of the domestic recovery.

And on the international front there has to be some information content in the fact that world equity markets have fallen by about a sixth since April.

In the month since the Reserve Bank lifted the official cash rate from its all-time low of 2.5 per cent the financial markets have gone from pricing in five, maybe six, more quarter-point increases over the eight opportunities in the next 12 months to four, maybe five.

Some economists, like NZIER's Shamubeel Eaqub and BERL's Ganesh Nana, question the need for the bank to raise rates at all at this point.

Why push up the cost of credit when the economy is so weak that credit growth is non-existent? The stock of bank loans did not increase at all over the year ended May.

Lending to households and farmers did rise, at historically torpid rates, but that was entirely offset by an 8 per cent decline in how much the business sector owes its bankers.

By the end of March the economy had clawed back half of the drop in output that occurred during the recession.

But as the Treasury reminded us this week, that overstates the rebound because it ignores population growth. In per capita terms we have only recovered one sixth of the drop suffered during the recession and are still 4 per cent below the peak in December 2007.

This recovery is slower than previous ones.

In the year to March the economy grew 1.9 per cent - better than nothing but only a third of the growth it had notched up in the first year of recovery from the previous recession following the Asian crisis of the late 1990s.

The June QSBO indicates that these rather underwhelming macro numbers are reflected in the accounts and order books of individual firms.

It is particularly disappointing, as Eaqub said, that the recovery in manufacturing has faltered, especially on the export side.

The building sector, too, is displaying renewed weakness, with hiring at its lowest level since 1998 and both output and new orders down.

These are two sectors which had been particularly hard hit by the recession. For their recovery to stumble so soon is dispiriting.

True, the QSBO does not include the agriculture sector, which has enjoyed a strong rise in commodity prices (though the latest Fonterra auctions suggest dairy prices may have hit the wall).

But as Bank of New Zealand economist Craig Ebert points out it does not include the public sector either, where belt-tightening is the order of the day.

There is some further stimulus in the May Budget but at about 1 per cent of GDP it is only a sixth of what has been dispensed over the past two years - mere embers among the ashes of fiscal rectitude and restraint.

That is even more true among bigger western economies.

JP Morgan economists estimate that deficit reductions across the Organisation for Economic Co-operation and Development (OECD) will cut growth by nearly a percentage point, or a quarter, next year.

It is not just a European story.

The most recent gusts of fear and despondency buffeting the markets have arisen from weak US data on employment, consumer confidence, factory orders and the housing market.

AXA chief economist Bevan Graham says that in the United States, and other heavily indebted developed economies (including ours), the recovery from a structural recession was always going to be hard work, and not proceed in a nice straight line.

Whittling down household and government debt will retard growth for a decade, maybe longer, he says.

So thank goodness for Asia and, by extension, Australia, then?

Up to a point.

The Reserve Bank of Australia said on Tuesday, as it left its OCR on hold, that China's growth was starting to moderate, but to a more sustainable rate, and that its own commodity prices, while off their peaks, were still at very high levels.

The RBA expects Australian growth over the coming year to be "about trend", with households displaying a degree of caution but business investment increasing.

Why then is our Reserve Bank intent on raising interest rates?

It comes down to the lags with which monetary policy works and to the bank's view of how much slack or spare capacity there is in the economy.

It has to scan a medium-term horizon. It takes anything from a year to two years for changes to interest rates it makes to influence first the level of demand and then prices.

After such a severe recession the amount of spare capacity is substantial but nonetheless finite.

The unemployment rate is still high by the standards of the four years before the recession hit, but it has peaked.

The QSBO has been recording an improving trend in employment - less job shedding, rather than net hiring - for a year now. Firms report greater difficulty in finding skilled labour, though at nothing like the levels prevailing in the last decade.

Investment intentions fell, but remain above their long-term average. "It could do with being better," Ebert said, "Still, it is consistent with ongoing recovery."

But only if businesses follow through.

On that score the hard data are not encouraging. Investment in plant and machinery, having jumped in the December 2009 quarter, dipped again in March according to the national accounts, while imports of capital goods fell too.

The Reserve Bank has revised down its estimate of the potential growth rate - the rate at which the supply side of the economy will grow - to just 2 per cent. Five years ago it would have said 3 per cent.

The lower that "speed limit" is, the sooner the current spare capacity will be used up.

Beyond that point allowing demand to grow faster than potential will not deliver more output and jobs, just inflation.

So the potential growth rate is a key judgment the central bank makes. It looks at such things as how fast the labour force is growing and trends in productivity.

In that respect, if business wants the bank to raise the speed limit it had better get investing, and the sooner the better.