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Economic Risks

The economic outlook, though moderating, remains positive. However, key areas of domestic uncertainty remain, including the outlook for inflation and potential output, the scale of the current migration cycle, the future path of house prices and the speed of the Canterbury rebuild and its wider economic implications.

Despite improvements in the prospects for the US and UK economies, the balance of global risks remains skewed to the downside. Growth is slowing in China and Australia while the outlook for Japan and the euro area remains weak. Downside risk remains for demand and prices of New Zealand's key commodity exports, particularly dairy. Geopolitical risk has increased since the Pre-election Update, with the situation in the Middle East and Ukraine deteriorating. New risks associated with Ebola have emerged.

The inflation outlook is a source of uncertainty...

Recent inflation outturns have been lower than expected. The factors behind the persistently lower inflation are not fully understood, leading to a higher degree of uncertainty over future inflation than normal. One possible cause is that potential output (the maximum level of economic activity that can be achieved while maintaining stable inflation) is higher than currently estimated, leaving a larger negative output gap (the difference between real GDP and potential output). As a result, inflationary pressures are weaker than anticipated. Under these circumstances, the Reserve Bank may choose to hold stimulatory monetary policy settings in place for longer. This would pose downside risk to the nominal GDP forecast in the near term, as price levels would be lower than in the central forecast. Over the longer term the risks are skewed to the upside as higher potential output would allow New Zealand to sustain a higher real GDP growth rate. Scenario two examines the impact of potential output growing more quickly than in the central forecast.

Another possibility is that inflationary pressures are present but taking longer than usual to impact on prices and wages. For example, following on from the experience of the global financial crisis, employees may be placing greater emphasis on job security than seeking higher wages. In this case the inflation outlook may be higher than recent outturns suggest. By putting upward pressure on both prices and wages this could lead to higher nominal consumption than otherwise. The extent and timing of such an increase in inflation would influence monetary policy settings. The impact on real consumption would depend on the relative changes in prices and wages. All else being equal, wages rising faster than prices would lead to higher real consumption.

...as is net migration's impact on domestic demand

Net migration gains remain elevated and judgements around the extent and timing of the cycle play a key role in the economic forecasts. The annual net inflow of migrants is now forecast to peak at around 52,400 in the first quarter of 2015, compared to a forecast peak of around 42,500 in the third quarter of 2014 in the Pre-election Update. The impact on the wider economy of higher rates of net migration will depend on the skill sets of the migrants and their geographic distribution. If the current strength in migration persists for longer than forecast it would put additional pressure on the housing market and add further impetus to domestic demand. However, higher migrant inflows to Canterbury could mitigate some of the capacity risks associated with the rebuild. The current migration cycle differs from previous ones, in that a large component is owing to fewer departures and the proportion of working-age arrivals is higher. The extent to which this changes net migration's economic impact, through its impact on productivity for example, is a further source of uncertainty.

Pressures remain in the housing market...

House price growth and house sales have slowed as higher mortgage rates and loan-to-value ratio restrictions (LVRs) have impacted mortgage lending. This slowdown in the housing market has been in contrast to the record net migration gains, which historically have increased the demand for housing. While higher net migration flows would pose an upside risk by increasing housing demand further, there could also be a delayed response to the recent increases in net migration that have already occurred, leading to higher demand for housing and possibly higher private consumption growth. Regional imbalances linger, as price growth in Auckland and Canterbury remains above the national average in response to strong demand. The timing of the removal of LVRs could also have a significant influence on developments in the housing market.

...and the timing and extent of the Canterbury rebuild remains uncertain

There is still uncertainty around the overall timing and magnitude of the Canterbury rebuild. Key determinants continue to be the pace of the settlement of remaining insurance claims (with around a third of private sector claims estimated to be outstanding) and the evolution of resource pressures in the construction sector. While the resolution of insurance claims has continued to progress, there are risks that the greater complexity of remaining claims could slow the rate of settlement. Recently this has been reflected in a slowing in the number of dwelling consents being issued. The availability and mobility of skilled labour will also impact on the pace of reconstruction if specific skill shortages act as bottlenecks in the construction industry. If the rebuild were to progress more slowly, residential and non-residential investment and employment growth could all be lower than in the forecast.

Risks from volatility in commodity prices are skewed to the downside...

Commodity prices for a number of New Zealand's key exports, especially dairy and to a lesser extent forestry, have fallen sharply this year. The outlook for dairy in particular remains weak (see box Dairy export prices and the New Zealand economy in the Economic Outlook chapter) and larger falls or a slower recovery in dairy prices than forecast pose downside risk through their adverse impact on farm incomes and the rural economy. Dairy farmers are particularly at risk should a second season of low farm gate prices occur. In contrast, meat prices, particularly beef, have continued to increase and should the upward trend continue for longer than currently anticipated this would create upside risk to the forecast. As a net oil importer, low oil prices owing to increases in global supply combined with lower demand growth form a positive risk to the New Zealand economy, although a further increase in geopolitical risks could bring an increase in prices (see below).

A further source of uncertainty is the one-year Russian agricultural import ban imposed in August, which impacts on a number of New Zealand's export markets such as dairy and apples (although New Zealand is not specifically included in the ban). An earlier removal of this ban could support a faster recovery in commodity prices, while a later removal could lead to more weakness in commodity prices as trade flows remain disrupted.

Given the relative weightings of the different export sectors and generally low global demand growth, risks to the forecast from commodity prices are tilted to the downside. Scenario one explores this further through simulating a sustained fall in the terms of trade caused by a broad-based fall in export prices.

…and risks to New Zealand's key trading partners remain...

Risks to the growth outlook for China remain, with GDP growth slipping below the Government's target. Concerns around the high level of local government debt, the

quality of lending in the shadow banking sector and exposure of financial institutions to housing market vulnerabilities persist. China's growth could slow more quickly than in the central forecasts if financial market disruption resulted in significantly tighter credit conditions. The People's Bank of China has been implementing some stimulus to address these imbalances and return GDP growth to the target of 7.5% but it will take time before the impact of the stimulus is known. Structurally, China is aiming to rebalance its economy away from investment-led growth towards private consumption. Rebalancing could lead to slower growth in the short term, particularly if this transition is disorderly.

Australian economic activity is relatively subdued, with consumer confidence, retail spending and job growth low. The slowdown in China also impacts on the Australian economy, particularly its export-orientated sectors such as mining and agriculture. As New Zealand's largest trading partner and source of foreign investment, continued weakness in Australia could impact on New Zealand via these channels. The Reserve Bank of Australia continues to maintain its accommodative monetary policy stance.

The economic outlook is weak in the euro area and downside risks remain. Sovereign debt issues have not been resolved and the pressure for increasing domestic competitiveness is high. Deflationary risks are increasing, leading to further easing of monetary policy by the European Central Bank, which has also left the door open for quantitative easing. The effect of this easing introduces further uncertainty to the outlook for Europe. A fall into deflation or a flare-up of sovereign debt issues could stifle the weak euro area recovery.

Japan's outlook has also weakened after an increase in sales tax reduced consumption, prompting the Japanese central bank to expand its asset purchase programme and the government to propose delaying further sales tax increases until 2017. Weaker Japanese activity could reduce export demand, particularly for economies in the Asia-Pacific region, many of which are also key trading partners for New Zealand. At the time forecasts were finalised, a snap election scheduled for 14 December was a further source of uncertainty.

...although the US economy is gaining momentum

The US economy continues to recover, with solid investment, consumption, construction and employment growth. Should the recovery accelerate further this would present a positive risk to the forecasts through its stimulatory effect on global demand. In particular, this may help boost export demand in emerging economies whose growth has slowed. October marked the end of quantitative easing in the US, although uncertainty remains over when monetary policy tightening will begin. Monetary policy tightening in the US and UK while the euro area and Japan ease may cause further disruption to global financial markets, as the divergence in monetary policy settings shifts financial and capital flows.

Geopolitical developments remain a concern

Geopolitical risk has increased since the Pre-election Update, as the situations in both Ukraine and the Middle East have deteriorated further. Recent developments have been watched closely by markets for any possible impacts on economic activity and energy supplies. While long-term implications of the recent geopolitical developments remain uncertain, further deterioration that impacts energy supplies may reverse recent price falls. Europe is particularly exposed to the Ukrainian situation given the trade links to Russia and the high proportion of energy supplies that is sourced from Russia.

Ebola has become more widespread in West Africa. While at this time it is unlikely for New Zealand to be directly impacted, potential reductions in global tourism and travel and disruption to trade may impact New Zealand indirectly should the situation deteriorate.

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