Tuesday, November 20, 2012

Outlook for monetary policy in New Zealand

Recent data has pointed to a soft patch in the New Zealand economy in the third quarter of 2012.  The September quarter Household Labour Force Survey (HLFS) was exceptionally weak with employment falling and the unemployment rate rising to a 13-year high.  Weak retail sales data has us now expecting GDP growth of only 0.2% q/q in the third quarter.

We have long expected that growth would be weaker in the second half of the year than it was in the first.  March and June quarter GDP results were both higher than expected for a total of 1.6% for the first six-months of the year (3.2% annualised).  My mistake was to bank those gains into higher expected growth for the year.  Prior to the revision down in Q3 growth I had expected annual growth of 2.6% in calendar 2012, which now looks like coming in at 2.3%. 

Annual growth drops down further to just under 2% (our estimate of New Zealand post-GFC potential GDP) in the year to March 2013 as the strong March 2012 quarter drops out of the annual calculation.  From there we continue to expect a modest recovery in growth over the course of 2013, largely on the back of stronger construction activity and not just out of Christchurch.

However it’s the labour market that has me most puzzled right now.  As I said in the post below, the weak reading from the HLFS was inconsistent with other labour market data especially wages, unit labour costs and anecdotal skills shortages.  Regular readers will know I believe that New Zealand’s rate of structural unemployment is higher than it was pre-GFC, but that shouldn’t be causing us too many problems just yet.  Furthermore, I just don’t believe the significant productivity gains recent ongoing growth but weak labour market implies. 

So what will the RBNZ think about all of this?  More importantly, what does it mean they are likely to do at the next Monetary Policy Statement on December 6th.

The last set of forecasts we have from the RBNZ are those incorporated in the September Monetary Policy Statement.  The near term growth numbers look weaker: we how have growth for the second half of 2012 at +0.7% for the half year compared to the Bank’s +1.1%.    The biggest change will be in the labour market where the Bank was forecasting an unemployment rate of 6.4% by March 2013 and 5.3% a year later, which we now have at 6.8% and 6.0% respectively.  Labour costs will be much in line with the previous forecast, but the starting point for inflation will be lower given the softer than expected Q3 inflation outcome.

But that’s where we think the differences will likely end.  Forward looking indicators are still supportive of the medium-term growth outlook still looking reasonably good, if not robust.  Consumer and business confidence are looking consistent with ongoing growth and recent PMI and PSI data from the BNZ suggest the September quarter weakness should prove temporary.  Another key indicator that has been supporting the broader recovery story is the nascent recovery in credit growth.  We are also increasingly confident of a modest recovery in global growth next year.  In particular we remain optimistic that US fiscal cliff issues will be resolved and China activity data is looking more upbeat.

We think the Reserve Bank will continue to forecast a pick-up in GDP growth and a reduction in the unemployment rate over the course of 2013 – but the difference will be the starting point.

Then there’s the housing market to consider.  Activity in the housing market is clearly improving.  Sales activity is recovering, house prices are moving up and housing permits are on the rise.  Importantly, this is not just a Christchurch phenomenon, other parts of the country are seeing recoveries  too.  One of the questions I get asked most often is whether there is a bubble forming in the Auckland housing market.  I don’t think there is, but there is clearly a shortage of housing in Auckland that requires a supply-side response.  So a construction-fuelled increase in activity is still on for 2013.  This is likely to be sufficient we think to see GDP growth up to 3.0% in the year to March 2014.

We also can’t ignore a number of post-GFC realities.  Growth was always going to be challenging, especially for the retail sector.  Consumption has been, and will continue to be, constrained by household deleveraging, the soft labour market and only modest wage gains.   These are at least partly a function of structural change, not tight monetary policy. Furthermore, it remains the case that some degree of economic rebalancing is desirable: i.e. away from consumption and housing and towards investment and exports.  These are all factors the RBNZ will be considering as it makes its decision on interest rates for the December MPS.

In the absence of a clear sign as to whether the recent weakness in activity will be sustained, they are likely to continue to assume that higher growth is still likely into 2013.  The RBNZ also needs to take a cost benefit approach to its decision on the 6th.  We don’t think a cut in interest rates right now will lead to a significant difference in growth.  Interest rates aren’t precluding higher consumption and neither are they precluding business investment and hiring decisions – other global and structural factors are at play.

The exchange rate is a bigger problem than interest rates.  Regular readers will also be aware that we don’t think a cut in interest rates will have much impact on the New Zealand dollar.  Interest rate differentials aren’t leading to a higher New Zealand dollar.  We put most of the “blame” for that on the still relatively high terms of trade and quantitative easing in other jurisdictions.  The new Reserve Bank Governor was of the same view in his maiden speech recently.

But what lower interest rates would do right now is provide further stimulus to an already recovering housing market.  That is undesirable from a medium-term  rebalancing perspective.  Calls for lower interest rates right now are missing the point.  New Zealand, like most of the rest of the developed world is facing structural issues that monetary policy is powerless to influence.  Higher productivity is the answer.

For me the most likely, and most prudent course of action  on December the 6th is for the RBNZ to leave interest rates unchanged.  They will however most likely shift out their expected tightening from the end of 2013 to the beginning of 2014.

 We have been expecting the tightening cycle to begin in mid 2013.  We now shift that out to the less definitive “second half of 2013”.  I’m still happy to be forecasting an earlier tightening than the RBNZ is likely shift to next month.  My assessment is they are underestimating some of the structural challenges in the economy, but we are still some time away from that becoming evident.