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Over the first half of 2016 the economy grew at a faster pace than was expected in the Budget Economic and Fiscal Update (the Budget Update), as did tax revenue. Forward indicators suggest this momentum has been sustained over the second half of the year. Support for growth is coming from immigration, tourism, construction and low interest rates, while weak global demand and the high New Zealand are providing headwinds. Judgements around how these forces will play out and interact with other economic drivers over the medium term are essential in forming our view of the economic outlook. In preparation for the release of the Treasury's Half-Year Economic and Fiscal Update (Half-Year Update), to be released on 8 December, this special topic explores the nature of the judgements required in the areas identified above.
Judgements on the drivers of economic growth…
Over the first half of 2016 growth in real GDP was buoyed by net migration inflows, construction and tourism. In addition, the terms of trade improved as dairy prices rose and the oil price fell. The net result was a 4.2% rise in nominal (or current price) GDP in the year ended June. This compares with expected growth of 3.5% in the Budget forecasts. As a consequence, the value of GDP was $1.7 billion higher than expected, which was reflected in tax revenue exceeding the Budget forecast by $0.7 billion. Most of the variance to the Budget forecast was driven by income tax paid by individuals, reflecting a stronger-than-expected labour market.
The external environment remained challenging over the first half of 2016. Trading partner growth was below average, monetary policy accommodation increased and CPI inflation receded further as energy prices declined.
The contrasting fortunes of the domestic and international economy have been reflected in the appreciation of the New Zealand dollar over much of the year to date. This appreciation, together with weak external prices more generally, has been contributing to very low rates of CPI inflation this year. However, over the past month, the TWI has depreciated and international oil prices have increased.
…will underpin the Half-Year Update
In the Half-Year Update we must make judgements on whether the recent drivers of growth, inflation and tax revenue persist, strengthen or subside over the next five years or so. We must also consider the interactions between these drivers and their implications for other aspects of economic performance, including the current account deficit and productivity.
Net migration inflows have added to the economy's productive capacity…
Since 2013, net migration inflows have added around 150,000 (or 4.5%) to the nation's working-age population. Over the same period, the number of people employed has increased by 250,000 and the number of people unemployed has decreased by 9,000 (together the number of people employed and unemployed create the labour force). That is, the inflow of migrants has been absorbed into employment, which has led to an increase in output. In contrast to the strength of labour supply growth, domestic demand growth has been around its long-run average. The corollary is that, in per capita terms, demand growth has been subdued. This is particularly evident in private consumption, where per capita growth has been advancing at less than 1% per year since early 2015, compared to an historical average of over 2% per year (Figure 1).
- Figure 1: Labour supply growth and real private consumption expenditure per capita
- Source: Statistics NZ
The overall balance between demand and supply in the economy is reflected in prices, and consistent with the relative strength in labour supply and relative the weakness of consumption demand, wage and price inflation has been low.
In the Budget Update, the Treasury forecast a further migration inflow of around 80,000 working-age migrants (or 2.2% of the working-age population) over the next four years. This inflow increased the economy's productive capacity by a similar proportion. That is, net migration inflows were assumed to increase the economy's underlying growth capacity by an average of 0.5% per year, which contributed to actual GDP growth averaging 2.9% per year between the years ending June 2017 and June 2020.
…and migration inflows may be slower to subside than expected in the Budget
In the Budget Update, net migration inflows were expected to subside from around the current level of 70,000 per year to 12,000 by 2019 (Figure 2). Key drivers included improved prospects for the global economy and a more balanced flow of migrants on student visas as the recent influx of arrivals completed their courses of study and left the country.
- Figure 2: Net migration assumptions
- Sources: SNZ, Treasury
However, the prospect of continued sub-trend trading partner growth, combined with recent signs that domestic growth will continue to outperform the Budget forecasts, suggests that New Zealand has become a relatively more attractive place to live and work. Indeed, Statistics New Zealand's (SNZ) most recent population projections include a cyclical migration assumption that is considerably stronger than previously projected (Figure 2), and well above the Treasury Budget assumption.
In sum, judgements around the level of migration inflows and their broad economic impacts (including on consumer and housing demand, the labour force and wages) have an important bearing on the outlook, including the overall size of the economy and thus the projected tax base.
Booming construction and tourism activity…
In the housing market, the increase in demand from migration is contributing to higher prices, although other factors, including low interest rates and expectations of future increases are equally important. Following several years of relatively modest levels of supply growth, consent issuance has increased in most regions. The Auckland Unitary Plan appears to support additional supply, and the government has allocated funds to better enable housing infrastructure development. Nevertheless, construction activity will need to be sustained at a high level for some time to meet demand and alleviate price pressures.
…is meeting capacity constraints
Some indicators suggest there is limited spare capacity in the construction industry at present. House construction costs are rising at 6.3% per annum, labour costs are rising faster than the national average and builders reporting greater difficulty finding skilled labour is historically high (Figure 3).
- Figure 3: Builders difficulty finding skilled and unskilled labour
- Sources: NZIER
Capacity pressures are also emerging in the tourism sector. Strong competition between airlines, growth in the number of routes and low fuel prices are helping to make travel more affordable, most notably for the Chinese population. This is putting pressure on accommodation, visitor attractions and other infrastructure.
Looking forward, our forecasts will need to incorporate judgements on the ability of these sectors to meet the capacity challenges they face and the implications this has for prices.
Low global inflation…
Interest rates in advanced economies are very low, in some cases below zero, as central banks continue to provide support for demand. Weak demand is also reflected in low commodity prices, particularly for energy and hard commodities, high unemployment and low global inflation. Long-term inflation expectations have fallen.
In contrast, growth in New Zealand is above trend and interest rates are relatively high. The relative attractiveness of NZ dollar assets is supporting the exchange rate at an historically high level. In addition, outside the dairy sector, prices for a number of export commodities are quite high. In the dairy sector, prices have lifted, although it is uncertain whether recent gains will be sustained. In the medium term, there are questions around where dairy prices will settle – the OECD-FAO recently downgraded their medium-term price projection. In addition, the path of the exchange rate will affect the returns to New Zealand exporters and importers.
...is affecting inflation expectations
- Figure 4: Inflation expectations and real 10-year government bond rates*
- * Real 10-year government bond rate is the nominal bond rate deflated by on-year ahead inflation expectations.
- Sources: Reserve Bank, Statistics NZ
Persistently low rates of inflation, both at home and abroad, have been accompanied by lower rates of expected inflation (Figure 4). These lower inflation expectations are embodied in wage and price setting behaviour which in turn means that there is less upward pressure on inflation. In the current low inflation environment, a fall in inflation expectations means that a given level of interest rates may have less impact on investment than has been the case in the past.
Other factors may also be contributing to low interest rates. In particular, there is some evidence that neutral real interest rates – interest rates that are neither stimulating nor restraining output growth – have fallen (Figure 4). Several developments may have contributed to this decline, including a greater propensity to save in the wake of the global financial crisis, slower productivity growth and slower growth in the working-age population of many advanced economies. In New Zealand, slower productivity growth is the most likely explanation for the trend decline in real interest rates. While the housing market and household credit is responding to low interest rates, the degree of stimulus being provided to business investment is less clear.
With the global outlook remaining subdued, global interest rates are likely to remain low for some time. With domestic interest rates likely to continue to offer relatively high returns, the New Zealand dollar is likely to continue to remain well support. However, the extent of that support will be tested by developments in the United States, where expectations of a rise in interest rates has strengthened in recent months.
Our judgements around the way inflation, interest rates and the exchange rate evolve in the presence of these forces affects the overall shape of the economic forecasts including the current account, nominal GDP and tax revenue.
-  “Shifting gear: why have neutral interest rates fallen?” Dr John McDermott, http://www.rbnz.govt.nz/research-and-publications/speeches/2013/speech2013-10-02
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