Rising inflationary pressures exacerbated by accelerating building activity pose a threat to New Zealand's economic growth and warrant a return to more normal interest rates, Reserve Bank governor Graeme Wheeler says.
The economy has been expanding beyond its potential growth rate for "some time" and inflationary pressures are beginning to appear, particularly in the construction sector where resources are being reallocated to deal with the Canterbury rebuild and Auckland housing construction, Wheeler said in a speech to the Canterbury Employers' Chamber of Commerce in Christchurch.
Construction is set to play a key plank in New Zealand's economy, with the Canterbury rebuild estimated to cost some $40 billion and Auckland targeting a build of 39,000 new houses over three years. That could put pressure on broader consumer prices if spare capacity is absorbed and starts facing constraints, forcing employers to bid up wages.
"An important risk to the expansion lies in the increase in inflation pressures, and the rising interest rates necessary to contain them," Wheeler said.
While an elevated exchange rate has kept a lid on tradable inflation, prices in the non-tradable sector are expected to accelerate "as the labour market tightens and capacity bottlenecks increase," he said.
"If actual inflation and expectations of future inflation were to rise significantly, competitiveness and real income growth would decline," Wheeler said. "The bank's subsequent efforts to maintain price stability by raising nominal and real short term interest rates would be more disruptive, the further inflation was allowed to deviate from target."
New Zealand's consumers price index rose at an annual pace of 1.6 percent in the December quarter, slightly ahead of estimates and creating uncertainty as to whether Wheeler would lift the official cash rate in his review, announced yesterday.
Wheeler kept the OCR at a record-low 2.5 percent yesterday, while signalling an increase would come soon to damp down building inflation over the next two years.
Today, he said the complexity of the current inflation environment was increased by 40-year high terms of trade, the elevated exchange rate, the reallocation of resources for construction in Christchurch and Auckland, rising consumer demand, increased net migration and the US Federal Reserve's scaling back of its quantitative easing.
Recent economic indicators showed stronger growth and inflation over the past six weeks than the central bank had built into its December projections, though rising house prices had moderated and the kiwi dollar was higher than expected. Those would be captured in the bank's next update to its forecasts in March.
"The exchange rate remains a considerable headwind for the economy, and the bank does not believe its current level is sustainable in the long-run," Wheeler said.
A sharp drop in the exchange rate can never be ruled out, especially when the currency is near historic highs, and would intensify inflation pressures, he said.
Such a fall could warrant an interest rate response if it was driven by investors reducing their holdings in New Zealand dollars with few fundamental reasons, a move which might not be needed if the terms of trade fell sharply, Wheeler said.
The New Zealand dollar dropped sharply following Wheeler's speech, slipping as low as 81.46 US cents, from 81.77 cents immediately its release at 1pm.
Another risk to New Zealand's economic growth came from over-valued house prices, exacerbated by high levels of household debt, he said.
"While a substantial fall in New Zealand house prices is unlikely, such a fall could happen if there was a marked deterioration in the household sector's ability to service its mortgage debt due to a sharp rise in unemployment, falling incomes, or very high domestic interest rates," Wheeler said. "A sharp correction of the type seen in several advanced economies in recent years would likely be accompanied by a domestic recession."
From October last year, the central bank imposed restrictions on the level of riskier home lending banks could write, and despite the limited data available, early indications suggest "housing turnover and the rate of house price inflation may be easing," he said. That could be due to the restrictions or other factors such as affordability, he said.
Wheeler also tagged a slowdown in global growth as a potential risk to the domestic economy, which has been supported by immense Asian demand for all of the country's primary commodities except beef.
"The areas of greatest risk lie in a potential faltering of momentum in the euro area, and the rapid build-up of debt levels in China, part of which originated in the shadow banking sector," he said.
Still, international institutions have revised up their global growth forecasts, and any decline in commodity prices would likely be offset by an improving outlook for the worldwide economy, he said.