STATE OF THE NATION
The New Zealand economy continues to perform strongly. Led particularly by the construction and tourism sectors, but pretty much across the board, GDP growth and labour demand is solid. Exceptionally strong net migration is boosting activity and spending, and increased housing market activity and house prices have boosted confidence around much of the country.
It is encouraging that the economy is performing so strongly. We expect the unemployment rate to continue to ease lower, despite our forecast that the economy will slow from a gallop to a canter as we approach mid-year, as capacity constraints (particularly for labour and credit) become more binding.
Capacity issues are a nice problem to have for firms, compared with lacklustre demand. However, at this ‘mature’ stage of the economic cycle, structural economic weaknesses can emerge as a degree of excessive risk-taking can occur on the part of households and firms. The Reserve Bank has been warning of the financial stability risks of the strong housing market (particularly in Auckland) for years, but has stopped short of raising the Official Cash Rate due to the fact that CPI inflation remains subdued. The macroprudential restrictions the RBNZ has imposed on riskier housing lending have put the brakes on to some extent, with Auckland housing market activity sharply lower, but experience with earlier rounds of LVR restrictions suggests the impact could prove short-lived as investors find their way around them. With the exception of severely stretched affordability the fundamentals for the Auckland market remain strong: rapid population growth, housing shortages, and historically low mortgage rates.
Although New Zealand’s net foreign debt is far lower than it was at an equivalent stage of the last business cycle (2006-7), and the current account deficit is contained, household debt as a proportion of income has risen to record highs. This is a predictable response to the fact that the economy has record-low OCR interest rate settings – lower than at the trough of the Global Financial Crisis – despite an economy that is growing around 3½%. Higher indebtedness means that when retail interest rates do rise – whether it’s deliberate policy, in that the RBNZ is tightening, or ‘exogenous’ (external, not planned), for example because global rates rise, or bank funding costs lift sharply – they will have a more marked impact on sentiment and spending than might have historically been the case.
The Reserve Bank will therefore tighten cautiously, not only for this reason, but also because they have been wrong-footed twice since the GFC, kicking off a tightening cycle only to have to reverse it (and more) as inflation has failed to materialise. We expect that OCR hikes are a 2018 story. And there is a fair amount of water to flow under the bridge before then. While the global economy and inflation are indeed strengthening, that in itself comes with challenges, after years of super-stimulatory monetary policy. It is yet to be seen how euphoric equity markets and very relaxed credit markets cope with higher US interest rates. For now, complacency rules, but that could change fast.