Budget 2006: Treasury predicts soft landing

Michael Cullen's budget anticipates a cyclic economic downturn. Picture / Reuters

The Treasury has cut its forecast of economic growth over the year ahead but is still expecting a soft landing.

It now expects growth to bottom out at 1 per cent over the year to March 2007, well down on the 1.7 per cent it was forecasting six months ago.

But it it is more optimistic than most forecasters about the speed of the export-led recovery to follow.

It has revised up its forecast for the year to March 2008 to 3.3 per cent, from 2.5 per cent last December.

That compares with forecasts of 1.7 per cent and 1.8 per cent by the Bank of New Zealand and Westpac respectively.

Finance Minister Michael Cullen said the economy had grown faster than Australia, the United States or the OECD average over the past six years.

It now faced a normal cyclical slowdown but prudent management of the public finances during the boom years meant the Government could manage its way through the downturn without taking "evasive action".

Fiscal policy - the level of and balance between the Government's spending and revenue - is expected to be more stimulatory in the year ahead than at any time since 1997, boosting the economy by the equivalent of 1.5 per cent of GDP.

In each of the two following years, the fiscal impulse is put at about 1 per cent of GDP. By contrast over the past six years, fiscal policy has generally had a constraining effect on economic activity.

The weaker growth the Treasury expects this year is driven by a softer labour market, yielding fewer new jobs and moderating wage growth, and by declining terms of trade as oil prices continue to rise while prices for New Zealand's export commodities continue to decline.

The deterioration in relative prices between exports and imports follows a five-year period when they improved by 17 per cent, boosting national income in the process. The decline the Treasury sees is mild enough to leave them still high by historical standards, underpinned by the effect of China's growth on commodity prices generally.

Another factor behind this year's slowdown is a cooling housing market.

In the 4 1/2 years from the end of 2005 to mid-2010, the Treasury expects house prices to rise only 4 per cent in all. It bases this on slower population growth, slower household income growth than in 2004 and 2005, and a return to a historically more normal relationship between house prices and rents.

The flattening of house price inflation is expected to turn off, or at least turn down, the boost to consumer spending from increased housing wealth, as home owners borrowed and spent on the strength of the higher value of the equity in their properties.

Inflation is expected to remain above 3 per cent for another year and the Treasury does not expect short-term interest rates to start falling until early next year.

The money markets have been pushing back their expectations of when the Reserve Bank will start easing to the point that they are now looking at the December monetary policy statement.

The Treasury believes wage inflation is close to its peak and set to decline as rising unemployment, lower business profits and the slowing economy generally take their toll.

The dollar is expected to keep falling but the Treasury says there is considerable uncertainty about how far and how fast.

Should it fall to 50 on the trade-weighted index by early 2008 (from around 62 now) economic growth will be stronger over the next couple of years than the central forecasts assume. But the Treasury also considers a scenario in which there is less labour hoarding by businesses, and in that case the growth outlook is weaker.

"We assume that businesses are able to see through the cyclical slowdown due to a period of previous strong profit growth and strong balance sheets. A key judgment is that firms hold on to labour in order to avoid constraints when economic activity picks up again in 2008 and 2009."

If it is wrong about this, growth in the year to March 2008 will be more like 2.5 per cent, compared with the central forecast of 3.3 per cent.

The benefits of a lower currency for the farming sector will be felt primarily in terms of improved returns. How much agricultural export volumes increase depends on climatic conditions.

But forestry may be better placed to take advantage of improved prices.

Tourism would take a year to feel the benefit as prices in that industry are set well in advance.

On the other side of the trade account, weaker consumer spending and a scaling-back of business investment are expected to see import volumes grow more slowly than the headlong pace of recent years.

So although current account deficit is forecast to widen to 9.5 per cent of GDP by the end of this year it should then narrow gradually to about 6 per cent by 2010.