Broadening the growth mix

Table 1.1

Dairy prices are set to stay low for longer, and it looks like residential building consent numbers in Canterbury have peaked.  Without these two clear areas of stimulus, economic growth is set to slow from 3.7%pa in September 2015 to 2.3%pa by the end of 2017.  Partly stepping into the void during 2016/17 will be construction activity in Auckland, as policymakers continue working to address the region’s housing undersupply.  Auckland’s construction boom will also have positive flow-on effects for the region’s broader economy, fostering growth in the services sector.  Although net migration will ease, working-age population growth will still be relatively strong, maintaining capacity in the labour market and helping to keep business cost pressures at bay.  GDP growth over the final two years of the forecast period is predicted to average 2.4%pa.

There should perhaps be little surprise in the gradual change of sentiment about the New Zealand economy’s prospects over the last few months.  The resumption of falls in dairy prices and ongoing questions about the robustness of global growth are continuations of a theme that has been evolving since early 2014, dragging business and consumer confidence down from the very high levels seen at the start of last year.  GDP growth on a year-end basis will reach an eight-year high in the September quarter, but is sure to slow after that.

In our March forecasts, we had taken a cautious view about the timing and speed of any recovery in international dairy prices, expecting Fonterra’s payout for the 2015/16 season to remain well below $6/kgms.  However, GlobalDairyTrade’s price index has plunged 29% since peaking in early March and is now at a new six-year low.  The drop has been partly driven by Fonterra’s need to reduce its product stock levels that had been built up late last year in the hope of a rebound in prices.  But international supply issues are also a factor, and raise serious doubts about whether Fonterra will be able to reach its forecast payout of $5.25/kgms this season.  We believe the final payout will be under $5/kgms – an outcome that will see many farmers running losses and place further stress on farm balance sheets.

The difference in economic effects between a one-year downturn in dairy prices and a multi-year drop in incomes is significant.  A drop in prices that was limited to the 2014/15 season would have had a relatively limited effect on the economy, particularly given that many farmers were in a good cash position following the $8.40/kgms payout of the previous season.  A temporary dip in prices would have seen farmers using up cash reserves and, if necessary, increasing borrowing to maintain similar levels of on-farm investment and spending.  But with dairy prices now set to remain low for at least 2-3 years, farmers will be battening down the hatches and cutting back on spending where possible to limit their losses.  The more pronounced negative flow-on effects for provincial economies with a significant dairy presence are obvious – effects that may also seep through into the urban centres as well.

The other external factor weighing on sentiment is the performance of the global economy.  The issue does not particularly show up in our forecast growth numbers for the world economy, but is more reflected in ongoing negative sentiment about the performance of our two largest trading partners, Australia and China.

The Chinese economy is still set to grow by about 7.0% this year, in line with the government’s growth target.  But the mix of growth is not quite what we might have anticipated a year ago.  The rebalancing of the economy, away from a focus on investment and exporting and towards household spending, is taking a breather as the Chinese housing market has stalled and domestic confidence has waned.  The central bank has eased monetary conditions and there are whispers of a bit more fiscal stimulus taking place.

If anything, though, the pressure for Chinese rebalancing is less pronounced than it has been in previous years.  On a TWI basis, the Chinese yuan has appreciated 13% over the last year – its fastest rise since 2008/09.  The associated reduction in the country’s balance of payments surplus and accumulation of foreign reserves has led the IMF to state that the Chinese currency is now fairly valued, for the first time in ten years.

For New Zealand, Chinese growth that is less consumption-focused suggests that achieving growth in agricultural export volumes will not be as easy.  Conversely for Australia, which is heavily reliant on shipping minerals and metals to China, export conditions may actually become a little more favourable.

That’s not to say that the Australian economy is going to recover rapidly.  Plunging commodity prices, relatively high unemployment, and record low interest rates are symptomatic of the struggles facing Australia at the moment.  Against that backdrop, it is remarkable that their economy is still set to grow by 2.5% this year.

The combination of a high cross rate against the Australian dollar and weak demand across the Tasman mean that the conditions faced by firms exporting to Australia will remain difficult over the next 18 months.

With the above factors raising doubts about overall economic growth, the Reserve Bank’s monetary settings have moved to an easing bias.  The shift in emphasis has been facilitated by consistent spare capacity in the labour market and the persistent lack of inflationary pressures in the economy.

Looking past the fact that the unemployment rate has only shifted from 6.0% to 5.8% over the last year, the labour market’s performance has not actually been that weak.  Employment growth in the year to March was 3.2%, but a combination of strong growth in the working-age population and a record high participation rate has meant that there is still a sizable number of people looking for work.  Wage pressures, and therefore business costs, have been kept in check.

With net migration set to remain strong throughout the forecast period, we expect working-age population growth to stay above its historical average of 1.3%pa until mid-2017.  We are also forecasting that the participation rate remains at or close to its current record high.  This relatively strong growth in the labour supply means that we are not forecasting the unemployment rate to fall below 5.2% throughout the next five years.  Wage growth will pick up from its current very low level, but given these labour supply conditions, it is still only forecast to average 3.1%pa between March 2016 and March 2020.  Furthermore, adjusting for inflation, wage pressures are expected to be very soft – implying that labour will remain affordable.

The extraordinarily high participation rate poses a risk to our forecasts, with the increasing proportion of people over 65 suggesting that participation could ease over the medium term.  Any reversal in the participation rate would result in less capacity in the labour market and potentially lead to more upward pressure on wage costs in a situation where economic growth is slowing.

Graph 1.1

Ordinarily, we would have expected the solid economic growth and strengthening demand conditions recorded over the last couple of years to feed through into some price pressures as businesses took the opportunity to fatten margins that had been squeezed since the Global Financial Crisis.  However, feedback from businesses is that competitive pressures from overseas are limiting the scope for firms to increase their prices.  The trend towards online shopping has meant that retailers have been struggling with this change for a number of years.  But intermediate goods providers are also facing significant competition from the increased accessibility of lower-cost products from overseas, which has led to weak price growth right throughout the value chain.

Although the latter trend is one that we have been aware of, we have arguably underestimated the potential disinflationary effect for New Zealand of the ever-increasing access to overseas products.  A slower pace of rebalancing in the Chinese economy has also fed through into less inflation in our forecasts.  These factors are partly counterbalanced by the inflation effects of a higher Chinese yuan, but we expect New Zealand’s medium-term inflation to settle at about 1.5%pa in 2019.

Graph 1.2

However, in the next three years we see scope for inflationary pressures to re-emerge.  These particularly relate to rising construction activity in Auckland.  The continued push by central and local government to boost the supply of new housing in the region, the certainty around planning and zoning provided by progress on the Auckland Unitary Plan, and the strong signal provided by the region’s rampant housing market to increase the rate of residential building will result in further substantial increases in construction activity in the region.  The associated demand for labour and capital will show through in strong building cost inflation, reflected in a pick-up in non-tradable inflation to an eight-year high (excluding the GST hike in 2010) of 3.3%pa by early 2017.  With the dollar trending downwards throughout 2016, headline inflation will also climb towards the top of the Reserve Bank’s 1-3% target band.

Over time, Auckland’s demand for capital and labour will be able to be met by the transfer of resources away from Canterbury.  Dwelling consent numbers in Canterbury have already peaked, and residential construction activity in the region is set to start winding down by mid-2016.  However, as indicated by our inflation forecasts, this transition of resources will not be seamless – which appears to be the Reserve Bank’s current assumption.  It is also important to remember that non-residential construction activity in Canterbury will still be increasing throughout 2016, which will place some limitation on the amount of spare resources becoming available to be transferred to Auckland.

The Reserve Bank is currently in the process of cutting interest rate, with the official cash rate set to drop to 3.0% by the end of September.  But with domestic inflationary pressures set to return next year, we expect the Bank to increase the OCR to 4.0% in the second half of 2016.  Although the surge in building costs and non-tradable inflation will be relatively transitory, the Bank will be keen to keep inflation expectations in check and maintain its credibility in controlling inflation.

The Reserve Bank will also find it has more scope to raise interest rates next year than was the case in 2014.  By the second half of 2016, we expect the New Zealand dollar to be at a four-year low on a TWI basis, and at a six-year low against the greenback.  Although the Bank is still likely to see the exchange rate as overvalued, the easing in the dollar will mean the Bank views the exchange rate as less of an impediment to rate rises than during 2014.  More stable export prices will also make the Reserve Bank more comfortable with lifting interest rates.

Gradual interest rate rises in the US and potentially the UK will also mean that the Reserve Bank is less isolated in lifting interest rates in the second half of 2016, compared with 2014 when global monetary conditions, if anything, were easing.

Over the medium-term, we are forecasting the OCR to settle at around 3.5%, with the Reserve Bank able to cut interest rates by late 2017 or early 2018 as inflationary pressures retreat.

One of the paradoxes of our latest forecasts is that, despite the less optimistic sentiment permeating the economy, we have revised up our forecasts of GDP growth between mid-2016 and mid-2017.  The change has been primarily driven by a rally in investment spending occurring during this period.

Looking beneath the headline number, the driver of this pick-up is construction activity rather than any significant strength in other investment, such as plant and machinery.  The growth in building will be primarily the result of substantial increases in residential construction in Auckland, as efforts to address the region’s undersupply of housing ramp up, more than make up for declines in residential activity in Canterbury.  Although large increases in residential construction in Auckland have been well signalled, gauging the timing of those increases is difficult given the important role that planning regulations and government policy play in determining activity.  We have brought forward the timing of growth in Auckland to reflect increasing pressure from central government to address Auckland’s housing shortage and the unaffordability of housing in the region.

Graph 1.3

Non-residential construction will also hold at a relatively high level, with rebuilding work in the Christchurch CBD a major component of activity throughout this period.

In summary, we expect GDP growth to average 2.7%pa over the five years to March 2020.  This result compares favourably with the average of the last 20 years (2.8%pa) and exceeds the 2.1%pa average of the 2005-2015 period, which was weighed down by the GFC.

Growth will slow to around 2.0%pa in the latter part of the forecast period as population growth eases.  However, per capita GDP growth will still be on a par with 2016 – highlighting the important role that strong net migration and population growth are currently playing in buoying up overall GDP results.

Graph 1.4