Transition of economic variables from the end of forecast

Given the difficulty in projecting cycles and shocks beyond the forecast horizon, the projections out to 2025/26 use trend or long-run averages for the growth rates or levels of key variables.

In previous forecast rounds the five-year forecast period was generally sufficient for the effects of current cycles and shocks to have worked their way through the economy. By the end of the forecast period key variables such as unemployment, the terms of trade and labour force participation have usually returned to trend growth rates or levels.

In recent forecast rounds, shocks to the economy, either on the demand or supply side, have caused key variables to remain above or below trend at the end of the forecast period. For example, in Budget 2010, some of the key economic variables were not predicted to fully converge to their long-term values at the end of the forecast period, owing to the persistent effects of the recession. Those variables were adjusted from their end-of-forecast values to the long-term averages, using a relevant rate of convergence for each variable.

In the Budget 2012 forecasts, the flow-on effect from the earthquake rebuild is assumed to continue into the early years of the projection period. Accordingly, real GDP growth is assumed to grow above the trend rate until 2018/19. Labour productivity growth is adjusted to reflect the faster real GDP growth track.

Four other economic variables have also been adjusted from their end-of-forecast values. These all contribute to the projection of nominal GDP, which is both a driver of a number of important fiscal variables, such as tax revenue, and the denominator in key fiscal ratios (ie, debt-to-GDP). These variables are:

• aggregate labour force numbers
• CPI inflation
• unemployment rate, and
• average hours worked.

From 2016/17 to 2018/19, labour productivity growth is modelled as a function of real GDP growth and labour force. From 2019/20 onwards, labour productivity growth is assumed to return to the estimated long-term value of 1.5% per annum.

For aggregate labour force numbers, the adjustment technique involves continuing to grow them at similar rates to those used at the end of the forecast period, with the Statistics New Zealand labour force projection growth rates taking over from 2019/20 onwards.

For the other three variables - CPI inflation, unemployment rate and average hours worked - a long-term average is determined, together with a convergence path. The long-term averages are based on historical data, making allowance for factors that could alter their future values, such as the Policy Targets Agreement with CPI inflation.

By 2020/21, all these variables have returned to their trend rates or levels.