Domestic Outlook (continued)

...but the pace of tightening is uncertain

Figure 1.20 - Exchange rate and 10-year interest rates

Sources:  RBNZ, the Treasury

The speed, timing and extent of future official interest rate rises will depend on a variety of factors including the strength of domestic demand, conditions in financial markets, and developments in the exchange rate. The transmission mechanism of official interest rates through the banking sector is also a key uncertainty. Banks continue to find the cost of funds elevated relative to their pre-global financial crisis levels, which has increased the margin between the Reserve Bank's OCR and retail interest rates. Ongoing uncertainty in international funding markets will remain an influence, while upward pressure on domestic funding costs is expected as domestic deposit growth slows and credit demand rises. All told, if these higher funding costs are passed on to borrowers, this would also lead to tighter monetary conditions than forecast.

Ten-year interest rates fell to an historical low of 3.5% in the September 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, as well as diversification by overseas investors in their search for yield.

The exchange rate is forecast to remain close to its current level until the first half of 2014. As mentioned throughout the chapter, the exchange rate is forecast to depreciate steadily from then on, reflecting the adjustment required to reduce the current account deficit to a sustainable level over time.

Stronger income growth expected

Figure 1.21 - Nominal GDP growth

Sources:  Statistics New Zealand, the Treasury

After falling to 3.4% in the March 2012 year, nominal GDP growth is forecast to increase only slightly to 3.6% in the March 2013 year reflecting the almost 7% peak-to-trough fall in the goods terms of trade. Nominal GDP growth accelerates strongly to just under 6% in the March 2014 year as the terms of trade rebound, before levelling off at around 4% in the final forecast years.

Nominal GDP is mainly comprised of compensation of employees, and business and agricultural operating surplus. These components are important for generating forecasts of tax revenue - a key consideration for the fiscal outlook.

Compensation of employees is forecast to grow by 3.5% in the year ending March 2013, and continues to grow at around 4% per year during the forecast horizon. This means that compensation of employees is stable as a share of GDP at around 45% from the March 2014 year onwards.

Having posted double-digit growth in the previous three March years, the agricultural operating surplus is expected to fall sharply in the year ending March 2013, with lower commodity prices and limited offset from the exchange rate. Agricultural operating surplus growth is expected to recover to around 13% per year in the later forecast years as prices for our commodity exports increase and the exchange rate falls.

Business operating surplus is expected to rise strongly in the March 2014 year reflecting an acceleration in Canterbury rebuild activity. Thereafter operating surplus growth slows to just under the pace of nominal GDP growth, in line with moderating non-agricultural activity.