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Budget 2005 Home Page Half-Year Economic & Fiscal Update 2005

Household Spending and Interest Rates

Since the beginning of 2004 the Reserve Bank has increased the OCR by 225 basis points, from 5% to 7.25%. During the same period floating mortgage rates have increased from around 7% to just over 9%, implying an increase of around 30% in the interest bill for a fixed level of borrowing. Yet to date interest rate increases appear to have had only a very limited effect on private consumption growth.

Figure 1.11 – Interest rates
Figure 1.11 - Interest Rates.
Source: RBNZ

Part of the reason for continued strength in household spending is related to the strong labour market, which has provided additional jobs as well as strong wage growth. Low unemployment by historical standards is also likely to have buoyed consumers’ confidence about job security and their ability to service increased debt levels in the future.

An additional factor has been the ability of mortgage borrowers to dilute the effect of higher short term interest rates by opting for relatively attractive fixed term rates. This opportunity has been available to borrowers due to a combination of low international and New Zealand bond yields, as well as active competition in the home-loan market towards the end of 2004 as banks actively competed to gain market share. As borrowers have opted to allocate a greater proportion of their mortgage debt to fixed rate loans, the percentage of mortgage debt on floating rates has fallen from around 34% at the beginning of 2004 to just over 20% in October 2005. Over the same period the percentage of mortgage debt with interest rates having an existing fixed rate period of up to 2 years has increased from 50% to 65%.

Figure 1.12 – Mortgage allocation
Figure 1.12 - Mortgage allocation.
Source: RBNZ

A consequence of the move to allocating a greater proportion of mortgage debt to fixed term rates has been that the effective (or weighted average) mortgage rate faced by households has not increased as rapidly as movements in the OCR. Between the beginning of 2004 and October 2005, the effective mortgage rate increased from approximately 6.9% to 7.6%, an increase of only 70 basis points compared to the 200 basis point increase in the OCR over the same period.

Over recent months fixed mortgage interest rates have increased. Over the next year or so a number of mortgage borrowers are going to have their home loans (or some part of them) come up for renewal. For a large proportion of these borrowers the lowest available rates available at the time will represent an increase relative to their current fixed rates. As a consequence the effective mortgage rate faced by borrowers is going to increase further, even in the absence of further increases in the OCR. The weighted average interest rate on mortgages due for renewal in less than a year was 7.3% in October 2005, with these loans representing just under a third of all mortgages by value. With one to two year fixed rate loans generally in the 8.2% to 8.5% range at the time of writing, borrowers will be facing higher debt servicing costs over the coming year.

Household debt levels have shown rapid increases over the past couple of years with mortgage debt estimated at $113 billion at June 2005, an increase of nearly $30 billion since June 2003. High debt levels coupled with rising effective mortgage rates will increase the debt servicing costs faced by households and contribute to a slowing in private consumption growth over the next couple of years. Debt servicing costs as a percentage of disposable income (prior to the deduction of interest expenses) are forecast to increase to 11.3% in the year to March 2007, up from 8.4% in 2004.

The extent to which households respond to increasing debt levels is an important judgement in the forecast. As the effect of higher debt servicing begins to impinge on household budgets there is a risk of a bigger slowdown if households become more uncomfortable about their debt levels. This may be particularly so if firms begin to shed some labour and the unemployment rate rises, making households feel more insecure or if a larger negative wealth effect eventuates from a slowdown in house prices.

Slower GDP growth cuts profits and businesses react by reducing investment and slowing their demand for extra labour …

Business investment growth is forecast to slow. Profit growth has been strong in recent years with steady growth in the operating surplus component of nominal GDP. The rate of growth is forecast to slow in 2006 and operating surplus is forecast to fall in 2007. Firms are forecast to respond by cutting back on some investment projects and reducing their demand for new workers.

… while lower profits lead to slower growth in company tax

Weaker profits are forecast to be associated with two years of weak corporate taxes. Corporate tax is forecast to grow 0.7% in 2007, before falling in 2008 as an increase in tax loss utilisation, following above average loss accumulation through 2007, slows revenue growth. As the loss effects dissipate, corporate tax growth recovers to an average of 8.5% over 2009 and 2010.

Figure 1.13 – Corporate taxes and operating surplus
Figure 1.13 - Corporate taxes and operating.
Sources: Statistics New Zealand, The Treasury

“Other persons” tax forecasts are substantially lower than in the Pre-election Update. As with corporate profits, the entrepreneurial income forecast now includes a noticeable business cycle, prompting more of a cycle in the other persons tax forecast. Although entrepreneurial income forecasts are used as the primary driver of other persons tax forecasts, the historical link between the two is tenuous. There are many other factors that affect this tax type, for example personal investment returns, taxpayer choice of business structure. Some of these other factors may be contributing to the generally downward trend in this tax type over the last two years. However, even with a prominent business cycle present in the forecasts, we expect growth in this tax type to average around 3.5% over the next five years.

Labour productivity growth is forecast to lift

Labour productivity growth made little contribution to GDP growth in 2005 and is forecast to make little contribution in 2006. In large part this reflects the strong cyclical performance of the labour market, which has seen employment increase strongly and unemployment rates fall. Labour productivity made larger contributions to growth during the early stages of the upswing in activity. Over the forecast period the contributions to growth from labour productivity increase, averaging 1.4% across the forecast period as a whole, exceeding the average of 1.1% between 1993 and 2005.

Figure 1.14 – Labour productivity
Figure 1.14 - Labour productivity.
Sources: Statistics New Zealand, The Treasury

The recent increase in employment and fall in unemployment is likely to have attracted an increasing number of inexperienced and lower skilled people into the workforce. As these people become more experienced, labour productivity is forecast to increase. The expansion in the capital stock, through strong investment, that has occurred since 2003 should also contribute to increases in productivity. In addition, despite the period of cyclical declines in investment as profits fall, the underlying trend in investment growth is strong. Coupled with weak employment growth this is forecast to see increases in the capital-to-labour ratio, which is another factor forecast to lead to higher labour productivity.

Table 1.2 – Supply-Side Sources of Economic Growth
March Years GDP per Capita GDP Growth Labour Productivity Growth Labour Input Growth
2003 3.1 4.7 1.6 3.0
2004 1.9 3.6 1.3 2.2
2005 2.6 3.8 0.4 3.4
2006 2.0 2.9 -0.5 3.5
2007 0.8 1.7 2.6 -0.9
2008 1.6 2.5 1.4 1.1
2009 2.9 3.8 1.9 1.9
2010 2.3 3.1 1.4 1.8

Sources: Statistics New Zealand, The Treasury

In the short-term the labour market may continue to be stronger than forecast …

The unemployment rate has steadily declined since 1999 to 3.4% in September 2005. Employment growth is forecast to slow as the economy slows and the unemployment rate gradually increases to 4.5%. The slowing in employment growth is forecast to begin from December 2005. In the Pre-election Update, employment growth was forecast to slow in the September quarter; however, the labour market has continued to perform more strongly than forecast. With current momentum in domestic activity it is possible that employment growth will continue to exceed the forecasts. Wage growth has picked up over the last 12 months, matching our Pre-election Update forecasts, reflecting reported difficulties firms are having finding staff. Annual wage growth is forecast to remain above 4% through 2006, helping to underpin income growth. There is a risk that wage growth may continue to rise in the medium term.

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