Domestic Outlook (continued)

...but the pace of tightening is uncertain

The pace and extent of interest rate rises are dependent on the strength of the exchange rate, the strength of domestic demand, and conditions in financial markets; a stronger exchange rate would also lead to tighter monetary conditions. Banks continue to find the cost of funds elevated relative to their pre-global financial crisis levels, which is increasing the margin between the Reserve Bank's Official Cash Rate (OCR) and retail interest rates. These higher costs are assumed to persist over the forecast horizon; international funding markets are expected to improve but to remain impaired; and upward pressure on domestic funding costs is expected as domestic deposit growth slows and credit demand rises. Further increases in the cost of funds would, if passed on to borrowers, reduce the extent of increases in the OCR required to meet the Reserve Bank's medium-term target of inflation between 1% and 3%.

Figure 1.21 - Exchange rate and 10-year interest rates

Sources: Reserve Bank of New Zealand, the Treasury

The rate of productivity growth is also critical to the inflation outlook. The Treasury forecasts assume labour productivity growth of 1.4% per year over the forecast period, similar to that over the decade prior to the 2008/09 recession. A lower rate of productivity growth would lead to a faster reduction in spare capacity and require an earlier tightening of monetary policy.

Ten-year interest rates fell to an historic low of 4.0% in the March 2012 quarter, reflecting lower yields internationally, but also some specific factors such as an improvement in investor sentiment as New Zealand's economic outlook has remained favourable relative to a number of other countries. Long-term interest rates are forecast to rise to a little over 5% by the end of the forecast period, reflecting the expected recovery in world economic growth and the gradual normalisation of global monetary conditions. The expected rise in 10-year interest rates flows through to higher business and government borrowing costs.

Stronger income growth expected

Nominal GDP growth is expected to slow to 4.1% over the year ending March 2013, reflecting the decline in the terms of trade. Nominal GDP is forecast to rise strongly in the following year as the terms of trade recover and the pace of growth in the real economy accelerates. Nominal GDP growth eases to around 5% per year in the last two years of the forecast period as real activity slows and the terms of trade level off.

Figure 1.22 - Nominal GDP growth

Sources: Statistics New Zealand, the Treasury

Nominal GDP is comprised of compensation of employees, and business and agricultural operating surplus.

Compensation of employees is forecast to grow 3.9% in the year ending March 2013, increasing to 5.2% the following year, underpinned by the firming labour market and the Canterbury rebuild. Compensation of employees continues to grow at around 5% per year through to the end of the forecasts. This means compensation of employees is stable as a share of GDP at around 44%.

Agricultural operating surplus is expected to fall in the year ending March 2013, reflecting lower commodity prices and the assumption that the exchange rate will provide only a limited offset. Operating surplus growth is expected to remain subdued in the year ending March 2014, but to recover strongly in the following years as the exchange rate falls and commodity demand firms.

Business operating surplus is expected to increase to 5.3% in the year ending March 2013, while the impetus from the Canterbury rebuild generates surplus growth of over 10% in the year ending March 2014. Operating surplus growth averages around 5% in the following years, in line with the moderation in activity across the economy.