Rating New Zealand's economic revival

It’s clear skies and good times across the Tasman. The New Zealand economy continues to boom, with strong demand from China and construction activity leading the way.

After gaining significant momentum last year, the Reserve Bank of New Zealand finally decided to raise its cash rate by 25 basis points to 2.75 per cent. Its last interest rate move was back in March 2011.

With momentum gathering and inflationary pressures mounting, the RBNZ believe that it is finally appropriate to begin unwinding the current level of monetary stimulus. This move today is set to the be the first of several during this year – with RBNZ governor Graham Wheeler suggesting that rates could rise a further 2 percentage points over the next two years.

New Zealand is in the midst of its own China-related boom, with its terms of trade at a 40-year high. Dairy prices, of which New Zealand is a large exporter, are booming, and strong demand is likely to keep the terms of trade at an elevated level over the next few years.

This naturally prompted the New Zealand dollar to push higher and today’s rate rise will only see it appreciate further. The high currency is a concern for the RBNZ and not sustainable in the long term. However, for now it largely reflects the strength of the New Zealand economy, the elevated terms of trade and the stronger outlook compared with many of its trading partners, including Australia.

Although the terms of trade boom is certainly helping the economy, the biggest driver of the recent strength has been the Canterbury rebuild following the devastating earthquake that hit Christchurch. This is expected to cost around NZ$40 billion.

The Canterbury rebuild is a difficult balancing act for the RBNZ. On one hand, living conditions and economic opportunities for many living within the region remain bleak. But the RBNZ also has to create sufficient capacity to allow this construction activity to occur without driving inflationary pressures higher. They cannot achieve both aims.

Australia suffered the same problem during the mining boom, as the Reserve Bank of Australia sought to create spare capacity for the mining sector by lifting rates high enough to suppress other parts of the economy. Naturally there were winners and losers, as their will be for New Zealand.

The New Zealand housing market appears to have eased a little in recent months following the decision by the RBNZ in October to introduce temporary macroprudential policies that put restrictions on lending with high long-to-valuation ratios. It has allowed the RBNZ to focus on setting policy for the broader economy rather than trying to negate an overheating housing market (A housing policy lesson from New Zealand, February 19).

With strong demand originating from China and the construction boom, the outlook for New Zealand’s economy is bright. Obviously the Canterbury rebuild will only be a temporary source of growth but while it lasts it will push growth well above its long-term trend.

The RBNZ currently forecasts that real GDP growth will be around 3 per cent in 2014, before pushing up to 3.5 per cent in 2015. Growth is then likely to slow a little as the effects of the Canterbury rebuild begin to diminish. (For more detail on the RBNZ forecasts, see its monetary policy statement.)

The New Zealand economy is in a good place right now and the RBNZ has set itself up nicely to balance the needs of the broader economy while providing sufficient capacity to allow the Canterbury rebuild to occur without driving up inflation. The cash rate rise today will be the first of several this year and the process of tightening is set to continue next year as well.