New Zealand Economic Outlook (continued)

...but set to strengthen as business confidence and output increase

The labour market is expected to strengthen over the forecast period, beginning in the second half of 2013. The Canterbury rebuild will be a large contributor to the strengthening, particularly in the 2014 March year, but a more widespread improvement is expected to occur across the country as output continues to increase. A turn in net migration, as fewer New Zealanders leave for Australia as the mining investment boom reaches a peak and the Australian economy slows, is expected to support the filling of skilled job vacancies and keep wage growth moderate. Signalled reductions in ACC levies are expected to generate some additional demand for workers, while ongoing welfare reform is expected to strengthen job-search incentives and have a positive influence on labour force participation.

Employment growth is expected to be positive in the first half of 2013, before accelerating as the recovery becomes more entrenched, giving businesses enough confidence to employ additional workers. Annual average employment growth is expected to turn around from a low of -0.8% in the June 2013 quarter to peak at 3.1% in the September 2014 quarter (Figure 1.18). Employment growth is then expected to moderate towards the end of the forecast period.

Figure 1.18 - Unemployment rate and employment growth

Sources: Statistics New Zealand, the Treasury

The strong employment growth is expected to drive a fall in the unemployment rate across the forecast period. The unemployment rate is expected to stay broadly steady at around 6.9% over the first half of 2013, before declining steadily, to slightly above 5% in March 2017. The rise in employment, fall in unemployment and pressures from the Canterbury rebuild are expected to put upward pressures on wages in the near term, with annual growth in average hourly earnings expected to rise to 3.2% in the December 2013 quarter, before moderating the following year. Over time, wage pressures will begin to grow again as the unemployment rate continues to fall.

Growth in compensation of employees, which is driven by changes in the number of hours worked in the economy as well as wage rates, is forecast to increase 2.9% in the March 2013 year, 3.9% in the March 2014 year and 4.7% in the March 2015 year as the labour market recovers and additional hours are worked. Higher wage rates will also contribute. Annual growth in compensation of employees is then expected to moderate slightly towards the end of the forecast period as employment and hours worked growth slows. Compensation of employees is an important contributor to forecasts of PAYE revenue.

Inflation low as exchange rate remains elevated...

Annual Consumers Price Index (CPI) inflation has been lower than anticipated in the Half Year Update. The main drivers for the lower result are a greater flow-through from a higher exchange rate and ongoing heavy discounting by retailers as they try to maximise sales volumes. The elevated exchange rate has contributed to negative annual tradables inflation; this has helped retailers, particularly those who sell imported goods, to keep prices low, as they operate in a highly-competitive environment. Annual non-tradables inflation remains below its long-term average, but still relatively high at 2.4% in the March 2013 quarter, given that spare capacity remains in the economy, keeping pricing pressures lower.

...but set to increase as spare capacity is used up and exchange rate depreciates...

While inflation has been low recently, both non-tradables and tradables pricing pressures are expected to pick up over the forecast period (Figure 1.19). Pressure on non-tradables prices will come primarily through a closing of the output gap as spare capacity is used up. Potential growth is forecast to increase from just under 2% currently and approach 2.5% near the end of the forecast period.[3] While the size of the current negative output gap is subject to uncertainty, the estimated gap of 0.8% of GDP in the March 2013 quarter is expected to be eliminated by mid-2014. Another factor that is likely to contribute to additional non-tradable pricing pressures is the Canterbury rebuild. It is expected that these pressures will be moderate as productivity gains are made, although there are risks to this judgement. These risks are discussed further in the Risks and Scenarioschapter. Higher government charges are also expected to contribute to non-tradables inflation, with higher tobacco prices in particular contributing around 0.4 percentage points to annual non-tradable inflation (or 0.2 percentage points to total inflation) in each year excluding the March 2017 year.

Figure 1.19 - Inflation

Sources: Statistics New Zealand, the Treasury

The exchange rate will be the main influence on tradables inflation over the forecast period. The NZD trade-weighted index (TWI) is expected to remain elevated over 2013 and 2014, before depreciating over the rest of the forecast period. This reflects the adjustment required to reduce the current account deficit to a sustainable level over time (Figure 1.20). As the exchange rate stops appreciating and then depreciates, there will be upwards pressure on tradables inflation. Risks around the path and pass-through of the exchange rate are discussed in the Risks and Scenarios chapter.

Figure 1.20 - TWI, 90-day and 10-year rates

Sources: RBNZ, the Treasury

Overall, annual CPI inflation is expected to rise to 1.9% in the March 2014 quarter from 0.9% in the March 2013 quarter. Inflation will increase only gradually from there, to 2.2% in the March 2017 quarter.

...leading to a withdrawal of monetary stimulus 

Over time, as the economy continues to grow and spare capacity is used up, monetary stimulus is expected to be progressively withdrawn in order to combat increasing inflationary pressures. The withdrawal of stimulus in these forecasts is more gradual than assumed in the Half Year Update as the result of lower-than-expected inflationary pressures to date. Ninety-day interest rates are expected to remain around 2.7% until the March 2014 quarter. After this, rates should rise gradually as inflation pressures increase. Ninety-day rates are expected to be 4.8% in the March 2017 quarter (Figure 1.20).

Ten-year government bond rates have been low over the second half of 2012 and early 2013 as New Zealand bonds have received additional demand from overseas investors looking to diversify portfolios. The New Zealand economy has also performed favourably on an international stage, attracting more funds. However, 10-year interest rates are expected to increase over the forecast horizon, primarily as global risk appetite increases as growth prospects improve. Typically this will reduce the demand for government bonds and increase demand for other higher-yielding assets such as equities, increasing bond yields - this is expected to be not only a trend in New Zealand bonds, but bonds around the globe. Ten-year bond rates are forecast to increase from 3.7% in the March 2013 quarter to 5.2% by the June 2017 quarter (Figure 1.20).

Stronger nominal GDP growth expected

Despite solid real GDP growth, nominal GDP growth (which includes price effects as well as volumes) has been soft over the past year. Nominal GDP growth for the March 2013 year is expected to be a modest 2.7%, down from 4.6% and 3.8% in 2011 and 2012 respectively. Weak pricing pressures have been the main reason behind the weaker nominal GDP result, with a high exchange rate keeping downwards pressures on tradables prices, strong competition and subdued demand engraining a discounting culture among businesses, and falling terms of trade also contributing. However, a strong turnaround is expected in the March 2014 year, with nominal GDP expected to rise 6.4%. This will primarily be driven by an increase in the terms of trade, but also a levelling off in the exchange rate and a pick up in demand across the economy leading to greater pricing pressures.

Figure 1.21 - Nominal GDP and terms of trade

Sources: Statistics New Zealand, the Treasury

Nominal GDP growth is expected to moderate somewhat later in the forecast period, as the total terms of trade level off and pricing pressures are restrained by higher interest rates. Nominal GDP growth is forecast to average 4.2% per year over the 2015 to 2017 March year period.

Nominal GDP is particularly important for generating forecasts of tax revenue. The main components of nominal income GDP, namely compensation of employees and business operating surplus, are inputs for generating forecasts of PAYE and corporate tax revenues respectively.