Economy is Extraordinarily Ordinary, says Westpac

Right now, the New Zealand economy is in an extraordinarily ordinary position. Unemployment, inflation and the exchange rate are all close to average or neutral levels. And the output gap tells us the economy is running neither above nor below its capacity ‘speed limit’.

‘Such a balanced situation is something normally seen in economics textbooks, not real life,’ says Dominick Stephens, Westpac’s Chief Economist, in the introduction to the latest Westpac Economic Overview. ‘The big question is whether the next phase for the economy is up, down or sideways from here.’

According to the Overview, ‘The global economy is slowing, but we think financial markets and newswires are overplaying the downside risks. The slowdown to date has been very consistent with our earlier forecasts. We expect global growth will keep ticking over, just not as vigorously as the 2017 peak. Crucially, we still expect the US Federal Reserve will lift interest rates this year, whereas financial markets have gone off the idea. If we are right, the New Zealand dollar/US dollar exchange rate will fall.’

‘In New Zealand there was a clear economic slowdown in late 2018, and it was deeper than we expected. But we expect momentum will be regained this year. Petrol prices have unwound most of their previous spike, which will allow bruised household wallets to heal. Government spending and a successful farm sector will be the other key drivers.’

‘That said, we retain our long-held view that the economy will slow again in the early 2020s. One major reason is that we are about to hit peak construction. Population growth is slowing more sharply than previously understood, and earthquake reconstruction is winding down. We expect residential construction to peak in 2019 and fall slightly from there. That will be a real change from the 2010s, when homebuilding activity more than doubled.’

‘Tying it all together, we expect the economy to remain in a fairly neutral position overall, so we are forecasting no change in the OCR for the coming three years.’

Impact of RBNZ bank capital requirements

In December the Reserve Bank proposed that New Zealand banks should be required to hold more capital. This is the subject of a special topic in the Overview, which is worth reading in full.

The RBNZ proposes that the increase in capital would take place gradually over five years, and envisages that banks would build up capital by retaining earnings rather than paying dividends.

The issue here is that capital is more costly for banks than debt, so requiring banks to hold more capital will increase their cost of doing business. Banks might absorb some of this as a lower return on equity but, to at least some extent, higher costs will be passed on to customers in the form of a wider margin between deposit rates and lending rates.

One key impact could be a tightening in credit conditions. ‘Banks can build the ratio of capital to risk-weighted assets in two ways – increasing capital, or restricting risk-weighted assets,’ explains the Overview. ‘Opting for the latter would mean banks becoming more restrictive on lending, with business and agricultural loans affected most.’ This would clearly affect franchise growth as franchisees' ability to arrange and service borrowing is reduced.

The bank’s view is that the proposed capital requirements would lead to higher lending rates, lower deposit rates and no change in the neutral OCR.

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