Executive Summary
Since the onset of the Global Financial Crisis (GFC) many forecasting groups in OECD economies such as the UK Treasury and the US Congressional Budget Office have successively revised down the potential growth rates of their economies, reflecting the fact that the credit-driven growth model in the years leading up to the GFC was not sustainable. Although New Zealand is far away from the epicentre of the crisis and does not have a large financial sector, New Zealand is not immune to the impact of the GFC on potential output growth. In the 2009 Budget Economic and Fiscal Update, the Treasury lowered the level of potential GDP in the 2013 March year by around 5% compared to the previous forecasts released in December 2008.
Like other countries in the OECD, New Zealand is grappling with the difficulties of measuring the underlying potential growth rate of the economy. In particular, the crisis has significantly increased uncertainty surrounding the estimates of potential growth and spare capacity of the economy. The amount of spare capacity is defined as the difference between potential output and actual output, where potential output is the level of output at which stable inflation is maintained.
This paper provides estimates of the potential growth and spare capacity of the New Zealand economy using a small macro model for the period 1994-2012. This methodology makes use of the theoretical relationships between inflation, unemployment, business survey indicators and the output gap to infer the level of potential output. This method allows us to take into account a wider range of economic data when reaching a judgement on potential output than do other methods currently used by the Treasury.
The new estimates suggest more spare capacity in the post-crisis period than other indicators used by the Treasury. According to the new methodology, the estimate of the output gap remains negative at around 2% in 2012. In contrast, other measures suggest that there was no spare capacity in the economy, i.e., a zero output gap. This finding suggests that the slow recovery in the economy after the GFC is partly due to weak demand in the economy.
Another key finding is that all the methods point to the onset of the slowdown in potential growth occurring before the financial crisis. A possible reason for this is that growth over the 2000s ultimately proved unsustainable as it was associated with large build-ups of household debt that could not continue indefinitely. As a result, the economy is going through a protracted adjustment period.
Although the main advantage of the new methodology is to incorporate additional relevant economic information, this new technique does not reduce the uncertainty in measures of potential output and its output gap as indicated by large confidence bands for the estimates. Furthermore, this new methodology, like other approaches, also suffers from the “endpoint” problem.
Whatever method is chosen for use, it is important to bear in mind that users need to understand all the judgements and assumptions behind the method as there are always implicit judgements built in to different approaches.
