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Economic Risks

Key judgements in the forecasts (see Key economic forecast assumptions and judgements box in the Economic Outlook chapter) are among the main risks to the economic forecasts.

Risks to global growth continue to be skewed to the downside. The US recovery remains on track with tightening of US monetary policy expected to begin soon, which may lead to the unintended effect of destabilising emerging market economies. Growth in China continues to slow, with risks of a sharp slowdown, while growth in Australia may remain below trend for longer. The realisation of any of these downside risks to the world economy would weigh on growth in the New Zealand economy. Risks remain around demand and prices for New Zealand's key commodity exports, with El Niño possibly leading to reduced supply through drought. Geopolitical tensions in the Middle East and terrorist attacks in Europe pose a risk to financial market and economic stability.

The outlook for domestic demand is balanced. High net migration, increased visitor arrivals and house prices present upside risks, while uncertainty around the effectiveness of monetary policy, inflation dynamics and productivity growth present downside risks.

Normalisation of monetary policy is expected in the US...

The US Federal Reserve is expected to begin tightening monetary policy in late 2015 or early 2016 owing to continued improvement in the economy and the labour market. However, uncertainty regarding the timing of the first move and the speed of tightening may lead to further financial market volatility, reducing confidence and subsequently demand. Once tightening has started, higher interest rates in the US may increase the attractiveness of US assets and lead to a re-pricing of risk, following a period of low risk premiums with investors seeking high-yielding assets. Increased demand for US assets and re-pricing of risk may prompt large capital outflows from emerging market economies, as well as tighter credit conditions and weaker exchange rates. If this were to eventuate, growth in emerging market economies would likely be softer, leading to weaker demand (and prices) for New Zealand exports.

...while there are risks of a sharper slowdown in China

In contrast to the US economy, risks to the growth outlook for China remain skewed to the downside. Annual GDP growth was on the lower side of the Government's target (around 7%) in September 2015 (6.9%) and economists are expecting a downward revision for 2016. In addition, financial market developments in mid-2015 - falls in the Chinese stock market and the depreciation of the Renminbi after liberalisation - have increased concerns that the Chinese economy is weaker than headline GDP indicates. A slowdown in China may be exaggerated by authorities not acting to support activity in order to avoid creating further imbalances, especially if the key risks of high levels of local government debt and a further slowdown in the housing market increase.

The direct effect on New Zealand of a slowdown in China may be offset to some extent by China's structural rebalancing towards consumption from investment as the main driver of growth. A successful rebalancing into more consumption-based growth would be positive for New Zealand by increasing Chinese demand for our primary products. However, a sharp slowdown in China’s growth would weaken demand for Australia and other trading partners in Asia, in turn lowering their income and demand for their exports, directly affecting New Zealand. Other risks to the Australian economy centre on the more gradual-than-expected transition in the growth drivers from mining to non-mining sectors, resulting in a longer period of below-trend growth. There is also some uncertainty about Australia's trend growth rate with slower population and productivity growth, a need for debt consolidation and lower trading partner growth.

Effect of El Niño is uncertain...

The nature and severity of any drought impacts from El Niño on agricultural supply and prices are uncertain, along with the eventual impact on economic growth (see El Niño box in the Economic Outlook chapter). If the drought was severe, it could lead to a sharp drop in dairy production and, initially, a further pick-up in meat production as more livestock may be sent to slaughter. In turn, dairy prices would likely rise and meat prices would initially decline, while the overall impact on nominal growth would be uncertain. On the other hand, a mild El Niño impact could lead to no material change in production or prices for New Zealand.

There is similar uncertainty about the effect of El Niño on other countries, with negative effects of reduced production for commodity exporters, while any rise in prices is positive for commodity exporters and negative for commodity importers. If the price of staple foods were to increase as a result of El Niño, this would reduce real incomes in emerging market economies and demand for other products, weakening global demand further.

...as is the evolution of dairy exports

As well as the concern around El Niño, the evolution of supply of and demand for dairy exports continues to generate uncertainty. Concerns of a temporary reduction in domestic supply from drought may have held prices up, although prices remain at low levels and are expected to recover only gradually. Growth in international production may also ease in response to lower prices, although these effects seem to be limited at this stage with the removal of the EU quotas, and US subsidies and EU intervention prices distorting price signals. On the other hand, Chinese dairy demand may pick up faster than expected, leading to dairy prices recovering earlier than in the central forecast.

Similarly, prices for other key international commodities are expected to remain subdued for an extended period of time, although the effects of this are uncertain. On balance, low oil prices are expected to be beneficial for growth in our trading partners. However, this positive effect may, at least temporarily, be largely offset by weaker export commodity prices in those countries as a result of generally weaker global demand.

Inflation remains low in advanced economies...

Falls in oil and other commodity prices, as well as weaker economic growth, have kept inflation low in most economies. Core inflation (excluding food and energy; ie, direct commodity price effects) remains below target in the major advanced economies, including the US. As interest rates are close to the zero lower bound, in the event of further weakness in advanced economiesthere is limited scope for increased monetary stimulus to provide a boost to inflation. If ongoing weakness in global inflation continues, tradables inflation in New Zealand is likely to remain low, despite the lower New Zealand dollar.

...possibly compounded in New Zealand by a change in inflation dynamics

As well as the potential for weak tradables inflation, the persistent weakness in domestic inflation and lower inflation expectations are generating uncertainty around inflation dynamics (see Why has inflation been surprisingly low? box in the Budget Update 2015 Economic Outlook chapter). In recent times, non-tradables inflation has been weaker than the long-term relationship with the output gap would suggest, and there is a risk that the historical relationship remains weaker for longer or does not re-assert itself. Similarly, the degree and timing of pass-through from the lower New Zealand dollar to tradables inflation may be more subdued than expected, particularly in the current low-inflation environment where businesses may be reluctant to pass on higher costs to consumers. If one or both of these risks were to play out, all else equal, headline inflation would be softer than forecast.

Uncertainty surrounds the sensitivity of demand to monetary policy settings...

Slowing domestic demand growth in New Zealand, despite interest rates considered to be well below estimates of neutral, has led to a questioning of the response of demand to monetary policy. Possible reasons for this may be a lower neutral interest rate than is currently assumed or that businesses and consumers require more incentive to spend because of heightened uncertainty in the current environment. If businesses and consumers are less sensitive to monetary policy than in the past, it would lead to a smaller boost to investment and consumption growth from low interest rates than in the central forecast.

...and labour productivity growth

The assumptions concerning labour productivity growth have significant implications for potential growth and the medium-term real GDP forecasts. Labour productivity growth is comprised of investment in capital and multi-factor productivity (MFP). In the central forecast, MFP growth recovers gradually to its historical average but there is a risk that it remains slower over the medium term. If this were to play out, real income growth would be lower, consistent with the experience of recent years, leading to lower domestic demand and slower growth in both real and nominal GDP (see Composition of growth box in the Economic Outlook chapter). Low productivity growth may reflect a combination of low inflation, interest rates and economic growth (sometimes referred to as ‘secular stagnation’).

Risk remains around the extent of the current migration cycle...

Net migration inflows remain elevated and judgements around the size of the current cycle are a risk to the forecast. Net annual gains are assumed to begin declining from a forecast peak of 62,700 in December 2016 as the weaker outlook for the New Zealand economy reduces its attractiveness for those on work visas and returning New Zealand citizens. It is difficult to gauge the strength and timing of these effects and risks appear biased towards higher migration, particularly with the inflow of students which may lead to structurally higher net migration gains. That said, with the New Zealand labour market and economic outlook materially weaker than a year ago, there is a risk that net migration inflows decline more sharply than in the central forecast, particularly if the Australian labour market materially improves.

Visitor arrivals have also been at all-time highs, leading to robust growth in travel services exports over the first half of 2015. There is a risk that the depreciation of the New Zealand dollar in the middle of 2015 has a larger effect and that higher-than-expected visitor arrivals and/or spending per visitor, particularly from China, lead to stronger export services volumes than incorporated in the central forecast. Similarly, arrivals on student visas are at high levels, with risks biased towards further gains, which would lead to increased education services export volumes.

...with high net migration expected to support housing demand

Housing demand is expected to be supported by net migration and low mortgage rates in the year ahead. However, housing demand might be weaker or stronger than in the main forecast, particularly given the risks around migration inflows. Declining nationwide house prices would reduce growth in residential investment and erode some households' wealth. Faster nationwide house price growth than in the central forecast would boost household wealth and consumer confidence, possibly leading to higher residential investment.

The Canterbury rebuild may provide a smaller contribution to growth than in the central forecast. The residential rebuild appears to have peaked, earlier than previously forecast, and uncertainty persists over the total size of the residential rebuild.

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