Economy set for recovery after lopsided 1999

By BRIAN FALLOW

WELLINGTON - In 1999 the economy shook off the Asian flu, the Reserve Bank discovered flexibility and electors voted for a less hands-off approach to economic policy.

The economy spent most of the year flying on one engine, consumption, while waiting for the other, exports, to kick in.

There are signs that is happening at last and the recovery is becoming broader-based and more robust. Accordingly economists are forecasting above-trend, but not rip-roaring, growth in the year ahead.

The most recent consensus forecast is that gross domestic product growth will pick up from around 3 per cent in the year to March 2000 to about 4 per cent the following year, before easing back towards 3 per cent again.

That would make this economic cycle much less of a rollercoaster ride than the last one. But it may make up in longevity what it lacks in excitement: 3 per cent is the usual estimate these days for the rate of growth, based on fundamental population and productivity trends, which is sustainable long-term without inflation becoming a problem.

The lopsided, consumption-led nature of the 1999 recovery was nowhere more evident than in the trade figures, with imports outpacing exports and the trade balance turning a deeper shade of red each month.

Some of that deterioration reflects cyclical factors. Imports have surged as the lowest interest rates in a generation have stimulated domestic consumption.

Exports, despite a weak exchange rate, have been slower to respond.

That reflects our continuing reliance on commodities, especially primary production, to earn our living in the world. Commodity prices have yet to pick up significantly in response to a strengthening world economy, though the expectation is they will.

And export volumes are only latterly starting to shake off the effects of two successive droughts.

Export volumes in the September quarter were up 4.4 per cent on the same period last year and back to the levels they were at two years ago, before the Asian crisis bit.

The deteriorating trade figures have dragged the balance of payments deficit from bad to worse. It is expected to get worse still as lumpy items like the second Anzac frigate add to an appetite for imports that as yet shows little sign of abating.

The consensus forecast is for the deficit, $6.6 billion in the year to September, to reach $7.8 billion by March next year, before returning to a still gaping $6.5 billion a year later.

At these levels the external deficit will continue to act as a drag on the economy, keeping the dollar lower and interest rates higher than they would otherwise be.

Exporters have had the benefit of a benign exchange rate over the past year.

On a trade-weighted basis the dollar ended the year 3.2 per cent weaker than it started and 9.5 per cent off its peak in May.

It is forecast to appreciate from here. The consensus in the New Zealand Institute of Economic Research's December survey has the trade-weighted index averaging 58.5 in the year to March 2001, about 7.5 per cent above its current level.

Interest rates were stable and low for most of the year, though they started rising in the last quarter.

While the lowness was cyclical, the stability reflected a change in the way the Reserve Bank signals monetary policy to the markets, with the switch last March from the ill-fated monetary conditions index to the official cash rate.

One of the big changes of the past year or so has been in the Reserve Bank's thinking about how to approach its task of maintaining price stability.

After reviewing the last business cycle the bank concluded that there is a trade-off between variability in inflation on the one hand, and variability in output and interest rates on the other.

In other words, if you are prepared to tolerate bigger fluctuations in measured inflation, you can have less of a rollercoaster in growth and interest rates.

And it appears the bank is prepared to tolerate more movement in the inflation rate because it believes inflation expectations are more securely anchored.

It went so far as to say, in its briefing paper to the incoming Government, that even when policy was consistently directed at staying within a 0 to 3 per cent range it would expect to be outside the range 20 per cent of the time, but that would still strike an appropriate balance between flexibility and credibility.

This is starting to sound not too different from the Australian approach, which aims to keep inflation between 2 and 3 per cent over the cycle.

The more flexible and lighter-footed approach, focused on medium-term inflation outcomes, is enshrined in a new policy targets agreement, which in effect is an employment contract between the Government and Governor Don Brash, signed on December 16.

That followed a general election which signalled a switch from the purist laissez-faire doctrines of the past 15 years in favour of a more interventionist approach.

Whether this amounts to a u-turn or a course correction should be clearer in 12 months.