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3 Risks and Scenarios (continued)

Economic Scenarios

Given the number of risks and unusual uncertainty, two scenarios which simulate the impact of alternative judgements on the economy are presented.

Figure 3.3 - Trading partner growth
Figure 3.3  - Trading partner growth.
Source:  Consensus Economics, The Treasury

A deeper recession

The first scenario (downside) is based on a weaker outlook for world growth where credit risks and conditions in the US and Europe become more severe relative to the main forecast. Amid financial fears, firms are reluctant to invest and households reduce consumption further. As a result, there is a deeper and more prolonged slowdown in the US and Europe which significantly dampens economic growth in China and other Asian economies. Under this scenario, trading partner growth decelerates sharply to 2.2% in the 2009 calendar year and rebounds to only 3.0% in the 2010 calendar year (Figure 3.3). Against this backdrop, New Zealand house prices fall by 25% from peak to trough which negatively impacts on consumer confidence.

Figure 3.4 - Real GDP
Figure 3.4 - Real GDP.
Source:  Statistics New Zealand, The Treasury

Model simulations indicate that the combined effect of these judgements would reduce real GDP growth by 0.3 percentage points and 0.6 percentage points in the March 2009 and 2010 years respectively (Figure 3.4). Relative to the main forecast, we see households spend less and save more, in response to the larger house price slump and tighter credit conditions. With slower growth, businesses not only decrease investment expenditure but also cut back on employment, with the unemployment rate rising to around 6.1% in 2010 and staying at that level until the March 2011 quarter.

As global risk aversion heightens and the world economy slows, commodity prices fall more than in the main forecast. In such an environment, the NZ dollar also depreciates sharply to 57 in March 2009 on a TWI basis. Although the exchange rate declines faster than in the main forecast, CPI inflation is around 0.9 percentage points weaker than in the main forecast in March 2010 because of subdued domestic demand (Figure 3.5). With lower inflationary pressure throughout the forecast period, a more accommodating monetary policy stance is required with 90-day interest rates reaching 5% in the March 2010 quarter, almost 200 basis points lower than in the main forecast (Figure 3.6).

Lower interest rates encourage a recovery in both business and residential investment in the March 2011 and 2012 years but consumers do not regain their confidence until the March 2012 year. As a result, economic growth picks up speed from June 2010 onwards. Overall, weaker real activity combined with subdued inflationary pressures results in nominal GDP growth being lower than in the main forecast for the entire forecast period with a cumulative impact of around $12.1 billion.

Stronger short-term outlook

The second scenario (upside) presents a growth path for the economy where three key judgements are slightly different from the main forecast - (1) stronger near-term growth outlook owing to a larger impact on private consumption of the tax cuts; (2) a slightly stronger housing market and (3) higher inflationary expectations.

Figure 3.5 - Inflation
Figure 3.5 - Inflation.
Source:  Statistics New Zealand, The Treasury

With respect to real GDP, the overall profile in this scenario is very similar to that in the main track, apart from the first year of the forecast period (Figure 3.4). In this scenario, real GDP growth in the March 2009 year is 0.5 percentage points higher than forecast in the main track. As the impact of the personal tax cuts on consumer spending is larger than assumed in the main forecast, this altered judgement increases consumption growth by 0.2 to 0.3 percentage points for the first three years of the forecast period.

Figure 3.6 - 90-day interest rates
Figure 3.6 - 90-day interest rates.
Source:  Statistics New Zealand, The Treasury

Model simulations show that inflation holds up higher than in the main forecast as inflation expectations remain high (Figure 3.5). In addition, stronger near-term domestic demand also puts further pressure on non-tradable inflation. In this scenario, the Reserve Bank continues to lower the Official Cash Rate (OCR) with 90-day interest rates reaching 7.5% in June 2009 and holds the OCR at this level for a year. As inflationary pressures abate, the Reserve Bank begins the easing cycle again in June 2010 with 90-day interest rates reaching 6.5% by the end of the forecast period.

Higher output and inflationary pressures, relative to the main forecast, lead to higher nominal GDP. As the price level is permanently higher than in the main forecast, the divergence in the level of nominal GDP between this scenario and the main forecast increases over the forecast period with the greatest difference of $2.2 billion in the year to March 2013. Relative to the main forecast, the total nominal GDP gains amount to $7.4 billion across the forecast period.

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