Westpac economists are forecasting 6% GDP growth in the year to June 2012, senior economist Dominic Stephens says.
In a weekly video update (see also above), Stephens said the near-term outlook for growth was poor due to the second Christchurch earthquake on February 22, with the possibility of zero per cent annual economic growth in early 2011.
This follows comments from Prime Minister John Key, who said the effect of the two Christchurch earthquakes would take NZ$15 billion out of GDP in the year to June 2011. Treasury is planning to release its assumptions on the effects of the two quakes on Sunday afternoon.
"There's actually a double-hit here. Some of that reconstruction activity that we expected to buoy the economy in 2011 has been delayed further, and also the loss of life, the ongoing nature of this event, could well hit confidence nation-wide," Stephens said.
Westpac expected the Reserve Bank of New Zealand would respond with a 50 basis point cut in the Official Cash Rate to 2.5% on March 10.
"Is that going to help with reconstruction? No, of course not - that's not the idea. The Reserve Bank is always looking to stabilise inflation and to stabilise the economy. This is an economy with very weak near-term prospects. The Reserve Bank has to act to shore that up," Stephens said.
However the picture looked quite different going into 2012.
"We have billions of dollars - possibly NZ$10 billion - of overseas reinsurance money pouring into New Zealand with the explicit aim of paying for reconstruction activity in the Christchurch region," Stephens said.
"We've also got a central government that's going to be borrowing heavily to rebuild infrastructure, and all of that is going to be jobs, activity and money flowing in the Canterbury region. Now it doesn't make us better off in the long-run, but it is going to help growth in 2012," he said.
"We're expecting 6% GDP growth in the year to June 2012."
Talking to interest.co.nz after the video was released, Stephens said the June 2012 annual GDP forecast was 5.7%, coming off 0.5% growth in the year to June 2011.
That would mean a lot of demand at a time where the economy's capacity to supply goods and services had been damaged, he said.
'Recipe for inflation'
"In other words it's a recipe for inflation. In particular, I'd expect the cost of construction to skyrocket. That could flow through to CPI inflation and will require a Reserve Bank response in 2012 and 2013," Stephens said.
"So we expect sharp OCR hikes over 2012, 2013, even into 2014 that could take interest rates far higher than they are today," he said.
Lower short term interest rates and the expectation of sharp increases in the future would mean a steep yeild curve where fixed term rates are much higher than short term rates.
Here is Westpac's full research note previewing next week's Monetary Policy Statement.
* We expect the RBNZ to cut the cash rate by 50bps to 2.50% next week.
* The devastating earthquake in Christchurch will dramatically alter the near-term outlook for growth; the knock-on effects to confidence and activity are unquantifiable.
* Much of the harm cannot be undone, but the RBNZ can at least act to shore up confidence and ease the burden on an economy whose short-term growth prospects have been stunted.
Like the rest of the country, the RBNZ's thoughts as it prepares next Thursday's Monetary Policy Statement will be dominated by the devastating earthquake in Christchurch on 22 February. At this early stage it's impossible to gauge the full economic and social impact, though it will clearly be some multiple of what was estimated for last September's quake. That uncertainty in itself presents a sizeable risk to the economy's near-term prospects, and not just within the Canterbury region. Our judgement is that the RBNZ will err on the side of shoring up confidence and easing some of the short-term pain, with a 50 basis point cut in the OCR next week.
Our call is less controversial now than when we made it a week ago, with a majority of analysts now expecting a cut of some size. Even so, we should spend a bit of time explaining the ins and outs of what will undoubtedly be a tough decision. And we should emphasise up front that this is not a claim about what the RBNZ 'should' do; the right response will become clear only in hindsight. Our pick is merely a reflection of what we would do in the same situation, given the balance of risks and our understanding of the monetary policy framework.
As was discussed in September, earthquakes tend to be ultimately inflationary. Over the medium-term horizon in which the RBNZ operates, repairs and reconstruction will lift the level of activity above where it would otherwise have been, soaking up some of the excess capacity that would have kept inflation pressures subdued. On balance, a major earthquake may require a steeper interest rate track over the medium term.
But that balance also requires a central bank to look through the near-term costs of disrupted activity. The RBNZ was able to do so in September, but the impact will clearly be much deeper and longer-lasting this time around. Indeed, this quake is doubly damaging to the near-term growth outlook, because much of the growth expected for the first half of this year related to reconstruction work from the September quake. And the disruption to activity won't be confined to Canterbury. Many New Zealand businesses have direct and indirect links to the region, and purchasing or investment decisions may be put off until the situation becomes clearer.
Our pick for a rate cut is not a comment on the state of the economy before the earthquake. The RBNZ had already recognised that activity was weak in the second half of 2010; whether it met the technical definition of a 'double dip' recession is a moot point (we've already seen that the economy shrank on a per capita basis in the June and September quarters). But there was a growing body of anecdotes and survey data that suggested the economy was regathering a head of steam in the early part of this year. The question now is how much if any of that momentum will be sustained.
What would cutting rates achieve?
The earthquake has caused much harm that cannot be undone by lowering interest rates. What the RBNZ can do, however, is to mitigate the potential flow-on effects to the wider economy via disrupted activity and the likely hit to confidence. The OCR is a blunt instrument, but that's also what makes it so effective in an emergency.
While the need to shore up confidence is a key part of the case for a rate cut, we're not proposing it simply as a symbolic gesture; there would still have to be a tangible benefit to the economy. We're seeing that already: lower wholesale interest rates, in anticipation of an OCR cut, have been passed through to some lending rates. Of course, for those lower market rates to be sustained, the RBNZ will still have to deliver.
Not everyone is convinced that lower interest rates would provide any benefit, or that they are the right tool for the job. We'd simply note that even those arguing against a rate cut are in agreement that the RBNZ should further delay the resumption of rate hikes. Let's think about what this would achieve: signalling a slower pace of tightening would push down the short end of the yield curve, just as an OCR cut would. So there's no real disagreement about whether rates should be lower, just about how much.
Why cut by 50bp?
This is admittedly the most uncertain part of our call; if cutting rates is intended as a morale booster, does the size matter? With immeasurably large risks to the downside, we think it better to err on the side of 'insurance'. Once an easing proves to be no longer necessary, it can be withdrawn fairly quickly - admittedly not without cost, since it would add to inflation pressures in the meantime. Our forecasts now imply that once rate hikes resume (in early 2012), the pace of tightening will be a little faster than previously, and given the greater extent of reconstruction activity that we'll see in 2012 and beyond, the OCR is more likely to peak on the tight side of neutral, rather than settling at neutral as the RBNZ had been aiming for.
Unlike last September, the RBNZ would have had just enough time to incorporate the earthquake into its MPS projections - though like our own forecasts, these could only be considered working assumptions at best. The main details are likely to be:
* Close to zero growth in the first half of this year, picking up in the second half as reconstruction resumes. Growth to slow to around 1% for calendar 2011 (no better than population growth), but then to accelerate beyond the 3.8% peak that was previously projected for mid-2012.
* Higher unemployment, lower business investment and construction over the near term.
* Underlying inflation (excluding government policy changes) well within the 1-3% target range for the next two years.
* A lower interest rate track over the next two years. To the extent that tighter policy is required in the future, it may be pushed out beyond the published forecast horizon.
A recent poll showed 13 out of 19 analysts expecting a cut next week, with nine of them plumping for a 50bp move. Interest rate markets have priced in 35 basis points of easing, suggesting a similar split of opinions. And the fall in the NZ dollar over the last week, most notably to a 19-year low against the Australian dollar, also reflects anticipation of a sizeable rate cut.
That might make it seem that the RBNZ is now obligated to deliver a 50bp cut - anything less might send interest rates and the currency higher again. But that shouldn't really be a concern; the RBNZ should aim for whatever level of interest rates that it thinks is appropriate. And in fact, there may not be much left to squeeze out of the market even in the event of a 50bp cut. The two-year swap rate has already fallen by 50bps since the quake; even we're not suggesting that an insurance cut would need to stay in place for that long.
(Updates with comment on 5.7% figure, full Westpac MPS preview note)