About the speech
The speech looks beyond the business cycle to explore New Zealand’s longer-term economic growth potential. It also discusses the neutral interest rate, including what drives changes in the neutral rate.
The speech is written by the Chief Economist and RBNZ staff and is not intended as an official Monetary Policy Committee statement. There will be no update on the state of the economy since the November 2024 Monetary Policy Statement. Recent economic data results from December and January will be discussed in detail in the upcoming Monetary Policy Statement on 19 February.
Watch a recording of the speech
Paul:
Tēnā koutou. Ko Paul Conway toku ingoa. I'm Chief Economist at Te Pūtea Matua, the Reserve Bank of New Zealand. Happy New Year. It's still January, so I think I can still say that. And also happy Lunar New Year, Chinese New Year, the year of the snake. I hope that bodes well for everybody. And thank you for tuning in for the speech on Beyond the Cycle: Growth and interest rates in the long run. I'm going to speak for about 25 minutes also. And then we'll have some q and a. So type your questions in into the slot on the website where you are watching, and we are going to try and get through as many of those as we can. Also, the print version of the speech, it should be up on the Reserve Bank website anytime now. And also I want to say, as you might've seen in the speech advisory, this speech is not intended to provide an update on the state of the economy from a monetary policy perspective.
It's more about long run performance and issues in the New Zealand economy rather than the quarter on quarter monetary policy stuff. Of course, we will be providing a full economic update and monetary policy decision in our monetary policy statement, which will be released on February the 19th. So inflation has returned to around 2% following an inflation surge that was, well, we haven't seen the likes of since the inflation targeting era began 35 years ago. And this disinflation has been achieved through an extended period of restrictive monetary policy that has reduced excess demand and inflation pressures in the economy. And the monetary policy committee, the MPC is confident that remaining persistent domestic inflation pressures will abate given that we have spare capacity in the economy currently. And over 2025 while necessary, the disinflation process has been challenging. So revised GDP data released at the end of last year show that the economic growth was stronger than previously measured over 2022 and 2023, and it also revealed that the economy slowed more dramatically through the middle of 2024.
Of course, the MPC, we will assess the implications of these GDP revisions alongside all the latest data during our upcoming deliberations. For the next MPS today, I want to go beyond the business cycle to consider longer term structural issues in the economy and how they influence monetary policy. So I'll discuss how potential output shapes the path for economic activity as the macroeconomic disruptions from COVID-19 fade into the past. I'll also highlight how potential output links to inflation and average per capita incomes. For New Zealanders, I'll outline the drivers of potential output growth and very briefly consider our prospects for improving productivity growth, which of course is a key driver of potential output growth. And in the second part of the speech, I'll discuss our assessment of the neutral interest rate, which shapes our expectations of where the official cash rate the OCR is likely to settle in the absence of future shocks.
And then I'll end with a general discussion on what it all means in terms of the outlook for economic growth and interest rates as we look forward into 2025 and beyond. Okay, so key insights from the speech include first of all, in the absence of future shocks. I'm going to be saying that quite a bit in the absence of future shocks. Economic activity in New Zealand will tend towards the level of potential output as pandemic related disruptions fade. Likewise, without future shocks, the OCR will tend towards the neutral interest rate in time. And of course, I'll describe what potential output and neutral interest rate is or are in a moment. So over the next few years with declining inward migration and weak productivity growth, potential output growth is likely to be modest. This means a modest speed limit on how fast the economy can grow without generating excess inflation pressures.
Second, unlocking higher investment and productivity growth is the key to raising potential output growth and per capita incomes, this would also reduce the likelihood of negative recessionary economic growth during future periods of restrictive monetary policy if we were able to lift our productivity performance and therefore potential output growth. And finally, reserve bank estimates suggest that the neutral interest rate has fallen over recent decades because of weak productivity growth in ageing populations globally and domestically, this decline it could be reversing, but on balance, we currently think that the long-term nominal neutral interest rate lies between two and a half and three and half percent. Okay, so let's start with where economic growth will tend to in the long run. The answer of course is potential output. So potential output gives us an idea of where economic activity is likely headed as the economic disruptions from the pandemic fade into the past.
So in the absence of future shocks of course, and I'll say a little bit about that at the end of the speech. So what is it? What is potential output? It's the level of goods and services that economy can sustainably supply without generating excess inflation or disinflation. So it's all about the supply side of our economy. And just to note that when I say sustainable, I mean consistent with low and stable inflation. I'm not referring to environmental sustainability, which is a whole other thing. So potential output, it depends on the supply of productive inputs. So that's capital. How much capital have we got, how much labour have we got, skills, et cetera, et cetera. And also how productively these inputs are combined to produce output. For example, if there are more people available to work, more capital to use or better ways of doing things, then potential output will increase.
Okay, potential output. It's the level, as I've said, it's the level of output that the economy will gravitate to in the long run once economic volatility due to the business cycle and shocks has played out. And you can see that in this graph. So potential output, that's the blue line in the middle there. It evolves relatively smoothly while actual output. That's the pink line there, moves around it driven by business cycle dynamics and one off shocks. Now we can't directly measure potential output. Instead we have to estimate it using techniques that separate our business cycle volatility from long run trends. And our central estimate, which I just showed you, it weighs up these different estimates. And of course there's considerable uncertainty as with many things in economics as to where potential output is at any point in time. Okay, so how does New Zealand's potential output growth compare with other countries?
We can compare our potential output growth across countries by looking at actual output growth over long stretches of time. So over the span of decades that business cycle volatility tends to cancel out. So let's look at GDP growth in New Zealand compared to the OECD average over the last quarter of a century or so to evaluate how our underlying rate of potential output growth compares. So this graph here, the pinky red line is real GDP growth in New Zealand, and you can see that it's often above the grey dash line, which is real GDP growth in the OECD. So relatively rapid real GDP growth over a long time horizon indicates relatively rapid potential output growth. But I want to dig a little bit deeper and doing so reveals that potential output growth in New Zealand has been driven more by increases in labour input rather than by improvements in productivity compared to other countries.
So in this chart here, the pinky red bar, that's the contribution to our long run. Growth from increases in hours worked and that's high for New Zealand. We're good at increasing hours worked, whereas the purple bar, that's the contribution of productivity growth to our potential output growth is relatively low. So we are less good at working productively. So compared to other developed economies, our long run economic growth has been labour intensive. We've tended to grow our economy by throwing more hours of work at it. Of course, strong growth in labour input. That's over the recent decades. That reflects generally strong inward migration into New Zealand in addition to increased labour market participation by New Zealanders. I also want to mention that growth in the capital stock, which is the blue bar here, has also contributed to potential output growth. But the amount of capital available per worker in New Zealand is low compared to other developed economies. And there's a couple of references in the printed version of the speech that explore that. So we are a capital shallow economy and I'll talk more about that in a minute. So just to sum up where we've got two growth in GDP and potential output has been relatively strong, but increased output has been spread across a fast growing population, working relatively longer hours per person. Now I want to explore this labour intensive approach to growth a little bit more. And we can do that by looking at cross country comparisons of GDP per capita.
Well first of all, GDP per capita, that's the value add per person in the economy. How much output, how much value add we create per person. And there are two ways to increase that. First of all, you can increase that by working more hours per person. That's working harder, we're quite good at that. Or you can increase it by, you can increase GDP per person value add per person by increasing how much value add or how much output we create per hour in each hour that we're at work. And that's working smarter, that's productivity and we're less good at that as we'll get to. So let's have a look at the data. So the purple line here is GDP per capita in New Zealand. We've expressed it relative to the OECD average. So that's the dash line at a hundred percent there. That's the OECD average.
You can see that GDP per capita in New Zealand is below the OECD average over the last 25 years, quarter of a century or so. So since the early 2000 GDP per capita has fallen from around 95% to just under 90% of the OECD average. So just to be clear, our GDP per capita, it has been increasing in New Zealand up until the pandemic, at least it's taken a solid hit the last few years, but not by as much. It hasn't been growing by as much as GDP per capita in other developed economies. So we are not keeping up now this relative decline in GDP per capita, getting back to the graph, it reflects declining labour productivity compared to the OECD average. So again, our labour productivity has been increasing, but not by as much as in your average OECD economy. On the other hand, hours work per capita has increased compared to the OECD average, but not by enough to offset the effects of declining productivity in New Zealand vis-a-vis the OECD average, anyone feeling like a frog in a pot of water that has slowly got hot because I am anyway, new Zealanders, we now work about 20% more hours per person, but we produce around 25% less output per hour compared to the average OECD economy.
And I want to say that it's important to say that hours work per person in the country and it's high mainly because of lots of New Zealanders work. So labour force participation is high here in terms of hours work per employee, per person in the labour force. We're around a little bit above the OECD average, but labour force participation is strong here. So by working harder, having lots of us in work, we have partially offset the effect of our declining labour productivity compared to the OECD average, but not completely. And also a couple of important points. This comparison is relative to the OECD average that's now a club of 38 countries. It includes several developing economies and our productivity performance is even weaker when we compare it to the more advanced OECD economies. So for example, just before the pandemic, the value created from an hour of work in New Zealand was about 24, about a quarter lower than it was, than it is in Australia and about 39, 40% lower than it is in the United States.
I also want to say New Zealand has not always been a productivity laggard. So in 1950, A GDP per capita was around 25% above the OECD average. So that's GDP per capita, a very rough measure of productivity at that time. Colonial ties to the United Kingdom provided access to capital expertise and secure markets for agricultural products at guaranteed prices. And this allowed for us to specialise in and build scale in agriculture an area of strong comparative advantage. Okay, so what does potential output have to do with inflation Potential output? We can think of it as the economy's speed limit. So it's the growth rate that the economy can sustain over time without triggering inflation pressures as productive inputs and productivity evolve. So too does potential output and therefore the economy's speed limit. And you saw that in that first graph, there are potential output. Now in normal times as a not during the pandemic, productive inputs and productivity evolve gradually.
So shifts in potential output are typically slow and steady. And again, you could see that in that first graph. But in that world, in that context, it's changes in aggregate demand that drives changes in capacity, pressure changes in our output gap in the economy. And consequently, it's typically changes in aggregate demand that drive changes in monetary policy interest rates. But over the pandemic, one of the defining sort of macroeconomic features of the pandemic was that supply shocks became much more prevalent and much more volatile. For example, because of our heavy reliance on imported labour when we closed the border, that resulted in an abrupt weakening in potential output, which hopefully you clocked in that graph earlier, even as our productivity growth temporarily increased at that time. So you can see that temporary increase in productivity on this graph. So this is labour productivity across a few countries over recent years.
But once we reopened the border, there was a pent up surge in inward migration into the country and that underpinned a temporary lift in potential output growth, more workers, more productive inputs, more potential output growth. But the other thing that happened at that time is that productivity growth went negative. So potential output growth as migration normalised potential output growth dropped well below its long run average. In terms of this chart, you can clearly see the recent negative productivity growth in New Zealand. Clearly it's the worst recent productivity performance across these countries by some margin. Okay, so what was the impact of this? These abrupt changes in potential output, they complicated the task of monetary policy during and in the aftermath of the pandemic. So to bring inflation back to target, GDP growth in New Zealand had to fall below the economy's reduced speed limit to lower excess demand and inflation pressures.
So this meant a period of weak and recessionary growth was necessary to return inflation to target within a reasonable time period. In contrast, if you look at economies with stronger productivity growth and particularly the United States here, they managed to reduce inflation pressures while sustaining considerably higher economic growth. Okay, so what does our low productivity and labour intensive approach to growth mean for kiwi incomes? So in broad terms, we can get higher per capita incomes by producing more output per person or by getting higher world prices for what is produced via improvements in the terms of trade. So higher export prices and or lower import prices. So producing more per person or getting a higher price for that output on world markets. So this is average income per person in New Zealand and in Australia, again, we've compared it to the OECD average. That's the grey dash line in the middle there.
So let's start with the good news and that is that since 2000 increasing prices for our exports, particularly for dairy and other agricultural products, coupled with weaker import prices, have resulted in a 40% terms of trade improvement. So by moving to higher priced exports and lower priced imports, we've improved incomes relative to the OECD average now for the not so good news. And that is that despite improvements due to the terms of trade, modest growth in GDP per capita has kept average incomes in New Zealand below the OECD average and on balance average incomes in New Zealand, they have improved only slightly compared to the rest of the OECD and remain below the OECD average. Of course there's other drivers such as our net investment position, et cetera, et cetera. But that's sort of the big story around New Zealand incomes in nutshell. Again, I want to make the point that this has not always been the case.
As you can see from this graph, average incomes in New Zealand in the 1950s as measured by GDP per capita were among the highest in the OECD. In fact, according to this data, we had the second highest incomes in the OECD across that group of developed economies in 1950. But since then, our GDP per capita average incomes have fallen. And currently we are around 20th in terms of the OECD ranking. And you can see from the graph that much of this relative decline occurred during the late 1960s and seventies as preferential access to markets in the UK was ending and the realities of our unhelpful economic geography started to hit home. As a result, New Zealand is no longer a high income OECD economy.
Okay, so what is the outlook for potential output over the next three years? We expect potential output growth to range between one and a half and 2% per year, and that's a lower economic speed limit than what we've had in the recent past. And it stems from expected ongoing weakness in productivity and also from lower net migration. Of course, this is only a forecast and our potential output growth will depend on policy settings and also on private sector decisions around investment, productivity and migration. After all, the best way to predict the future is to create it. Now notably New Zealand, we've got our productivity, as you saw, is now well below the OECD average and that of more advanced economies and this productivity gap, it implies significant opportunities for New Zealand businesses to adapt and adopt existing technologies that other global firms are using and use technological adoption to catch up to the productivity levels of businesses in leading economies.
Now, I know that is more easily said than done. If it wasn't, we would've done it already. And in fact, it is really difficult. And I say that because reforms aimed at improving our productivity performance would have to mitigate some deeply entrenched structural issues that have held back productivity growth in alero New Zealand. First for a small economy, New Zealand is poorly connected internationally. So for example, our trade intensity exports and imports relative to the size of the economy is among the lowest across small developed economies, and it's even weakened further in recent years. So this chart sort of gives a hint of that. This is exports as a share of GDP, it's low in New Zealand and it's declined over recent years. It's a bit hard to sort of understand this chart, but all the charts are in the speech that's been published on the line, so you can have a good look at them then.
But in any case, this low and declining export performance is very disappointing and costly for a small open economy. We sort of have this image of ourselves as an open economy trading with the rest of the world, but our trade performance is not that strong and is getting worse. Foreign direct investment in New Zealand is also typically below the OECD average, okay? So we're not as well connected internationally as we ideally would be. And this international disconnect, it limits the diffusion of new technologies into the country. We're a bit of a technology laggard in some ways. And when you combine that international disconnect with small and insular domestic markets, it also limits scale of our businesses and markets. It limits competition, it limits innovation, and also the efficient allocation of resources and all of those are fundamental to improving our productivity. Now the second sort of big structural challenge for New Zealand is the flip side of our economy being labour intensive is that it is capital shallow.
So the New Zealand economy lacks capital business investment is a share of GDP has been slightly below the OECD average, but it has been spread thinly across a rapidly growing workforce. So financial flows into housing have been prioritised over investment in productive businesses. There's also, among our corporates and bigger businesses, there's an emphasis on paying dividends rather than on reinvesting and going for growth. And there has been high dividend flows offshore, given extensive foreign ownership in core economic sectors. The New Zealand equity market is also very small relative to the size of our economy, and many significant New Zealand businesses are structured as co-ops or partially government owned. And all of this makes third party investment challenging. Now, the third structural reason in behind our poor productivity performance is that investment in knowledge-based capital is also relatively weak among New Zealand businesses, knowledge-based capital. So improving productivity, it requires investment in r and d, research and development, investment in innovation, education and skills, organisational know-how and managerial capability, and these are all areas where New Zealand tends to lag.
Okay, so can productivity growth be improved? And clearly is the answer to that one. And I would say that thanks to the work of the now defunct productivity commission and others, I think we do have a reasonable sense of what a productivity reform agenda would look like. In short, such an agenda would emphasise strengthening international connection, fostering capital, deepening, and that includes infrastructure and also enhancing competition underperforming service sectors. And yes, that includes the banks as well as driving more effective innovation. Setting appropriate policies for the long run would also enable investment or help enable investment and co-investment at scale by local and global partners. Of course, the Reserve Bank, we have an important role to play in all this, most obviously for someone on the monetary policy committee by maintaining low and stable inflation, monetary policy supports investment in the economy and productivity growth, but some of our other areas of responsibility are also key.
So under our financial stability remit, we keep the financial system stable and secure. We ensure that banks well, that ensures that banks and insurers and financial market infrastructure operates safely and efficiently. Of course that supports borrowing savings and investment and therefore productivity and economic growth. And we're advancing key initiatives to deliver these outcomes. That includes the Deposit takers Act, which should deliver or will deliver a modern, consistent and transparent prudential regime. We're also upgrading the regulation of financial market infrastructure and reviewing insurance supervision. We're advancing payments innovation. We're exploring a central bank digital currency, and as part of the Council for Financial Regulators, we are enhancing the payment system to support open banking and digital identity. Open banking, a key mechanism for improving competition in the banking industry. We're also tackling issues such as limited access to capital for Maori businesses and also barriers to private investment in climate change solutions.
Now the last point I want to make on improving productivity and potential output is that it's not solely the responsibility of the government and the public sector to get this right, ultimately lifting productivity. It's largely up to the private sector. And there are many ways New Zealand businesses can enhance their performance. For example, by embracing e-commerce to expand markets and geographic reach, or by looking at the technology that leading global firms in your industry are using and figuring out how to adapt and adopt or adopt and adapt that to the New Zealand context. Individual New Zealanders can also have a role to play in lifting productivity as well as keeping your skills up to date consistent with a 21st century economy. Vote with your feet, shop around. If you don't like a deal being offered by a bank or a utility provider for example, then go ask another one for a better deal.
Make them work for your business. Okay, enough on potential output and how to improve it. Let's talk about the neutral interest rate. So just as potential output growth determines where GDP growth will gravitate to in time the neutral interest rate guides where the OCR will tend towards in the long run. So the nominal neutral interest rate, sorry, too many ends in that sentence, is the level of the OCR that's consistent with inflation being sustainably at target and the economy running at its potential output. So when the OCR is above neutral, monetary policy is restraining demand and inflation pressures and below neutral monetary policy is stimulatory. Now, like potential output, the neutral interest rate unfortunately cannot be directly measured. So instead we have to estimate it. We've got five different techniques that we do that with and we average the results of those techniques to inform our baseline level of the neutral interest rate.
We then add expected inflation in 10 years time, which gives us an estimate of the long run nominal neutral rate, which is then used to assess the policy stance associated with any given level of the official cash rate. So what drives changes? How come the neutral rate changes over time? And it reflect the answer to that question is that the neutral interest rate, it reflects the balance between total savings and total investment in the economy. So if there's increased demand for investment funding for whatever reason, or if there's a lower savings rate, then that would put upward pressure on the neutral interest rate. How much people save is shaped by factors such as income and life expectancy. So ageing populations tend to save more for retirement and of course tax and savings policy, for example, the extent of compulsion can also influence savings. Now, investment decisions they depend on expected return investment preferences, pressing needs such as climate change mitigation and adaptation productivity growth, as well as being a key driver of potential output.
It also influences the neutral interest rate. For example, improved productivity would add upward pressure to the neutral interest rate because it would encourage firms to invest. They would see productive opportunities for investment and get into it. Higher productivity may also lead people to anticipate higher lifetime incomes and therefore save a bit less as a result, which would also put upward pressure on the neutral interest rate. Now of course, the neutral interest rate, it shifts over time as the balance between savings and investment in the economy changes. So this graph here, the pink line in the middle there is our point estimate of the neutral interest rate. You can see that between 2008 and 2019, that central estimate suggests that the neutral OCR fell by around two percentage points and forthcoming reserve bank research identifies it finds that global factors along with New Zealand's slowing productivity growth have been key drivers of that fall in the neutral interest rate, whereas New Zealand's rapid population growth, that's the blue bit in this chart here, has put upward pressure on the neutral interest rate.
So just to delve into that a little bit more. Over the 1990s, the world neutral interest rate fell for a number of reasons, including increasing savings and also cheaper investment goods. China had a fair bit to do with that and that downward trend, it continued after the global financial crisis because of fiscal consolidation and greater demand for safe assets along with ageing workforces. Now domestically sluggish productivity growth may have, well, as I kind of hinted at earlier, may have reduced businesses incentives to invest and it may have led households to save more than they otherwise would have for retirement, although we don't save a great deal in this country. But in any case, those domestic developments put further further weight on the mutual interest rate driving at a bit lower. And as I said, rapid population growth, it only partially offset these effects. So we've got more people coming into the country and natural population growth, more young households compared to other parts of the world who tend to save a bit less than older households putting upward pressure on interest rates.
So this decline in the neutral interest rate you would've noticed from that chart two graphs ago. It's recently stalled and it may have even reversed as some evidence of an increasing neutral interest rate over the last few years. But the jury is still out on whether this increase will continue into the future. So on the one hand, the main drivers of the low neutral interest rates such as ageing, longer lived populations, weak productivity growth, they're unlikely to change anytime soon. And also an increasingly fragmented and slow growing world economy that all may also discourage investment again, suggesting that that increase in the neutral interest rate may be short-lived, but on the other hand, pushing in the other direction, the neutral interest rate could increase further from here. Given increased investment in mitigating and adapting to climate change or an increased defence spending across the world, given an increasingly uncertain global environment, of course prediction is difficult, but without another large negative economic shock, a return to the ultralow interest rates seen during the early stages of the pandemic is unlikely anytime soon.
Okay, getting towards the end, we're getting through it. What does all this mean for economic growth and interest rates? So I've outlined how slow potential output growth recently may have meant a lower growth speed limit with which to reduce inflation here compared to some peer economies. Looking ahead, as I mentioned, this low speed limit may well persist into future. So looking ahead, as I mentioned earlier, this low speed limit may well persist into the future. We do expect GDP growth to pick up over the next couple of years in response to less restrictive interest rates among other things which we'll get into in the next NPS. But this is a cyclical pickup in growth. We're coming out of a hole so it's cyclical and our longer term growth prospects remain modest, given weak, expected productivity growth. Now let me quickly add that all of those forecasts are from our November NPS.
So they reflect policy settings at the end of last year and of course I would love to be surprised to the upside in terms of our forecast for potential output. It's not often that I hope that we are wrong, but this is the exception now on interest rates at 4.25%. The OCR is currently still north of neutral and therefore restrictive against our reserve bank estimates of the long run nominal neutral interest rate being between two point a half and three point a half percent. As we signalled in the November monetary policy statement, easing domestic pricing intentions and the recent drop in inflation expectations help open the way for some further easing. Of course, as I've said a few times now, we will be revisiting all of this in our February, 2025 forecast round. The other point I'll make about this is that because of uncertainty in the neutral interest rate, we will need to increasingly feel our way as the official cash rate gets closer to our estimate of neutral.
So we will be continually cross-checking our neutral estimate and comparing where the OCR is relative to neutral with what we are seeing in the real economy. For example, if our estimate of neutral is too low, then we would see economic activity and inflation pressures pick up by more than expected as monetary policy settings would have been less restrictive than originally intended. Of course, we also update our estimate of the neutral interest rate as part of every policy round. So we're constantly looking at that. There's been plenty of examples in the recent past where we've nudged it up a bit consistent with what you saw in the graph. Okay, so to conclude, what have we talked about historically? New Zealand, our long run growth, it's often outpaced the OECD average, but it's relied heavily on immigration and working longer hours per capita to make up for producing less per hour of work.
In part, this reflects a small distant and capital shallow economy where capital per worker has lagged that in peer economy. So the failure of capital per worker investment to increase the level seen in more advanced economies has been a key factor. Holding back labour productivity and unlocking higher productivity growth and investment would raise the speed limit for sustainable long run growth in New Zealand and make further periods of disinflation, less recessionary, improving productivity. It would also help address many of the other challenges that we currently face from fiscal policy to healthcare education infrastructure along with a more environmentally sustainable economy For individuals, better productivity would mean more choices, higher long-term prosperity and more leisure. So productivity, it doesn't solve everything, but it almost does at the current juncture. In the absence of future shocks, we expect output growth to tend towards potential growth rate and interest rates to ultimately settle around neutral.
However, and it's a big however, the COVID-19 years, they've been a stark reminder that multiple shocks from a variety of sources can occur in a short space of time. So looking ahead, climate change, ongoing geopolitical uncertainty, possible corrections and global financial markets will likely mean an increasingly volatile economic outlook. And as we noted in the November statement, having consumer price inflation close to the middle of the target ban puts the monetary policy committee in the best possible and the New Zealand economy in the best possible position to respond to ride out future inflation shocks. And that is all I've got to say as far as the speech goes. So ngā mihi nui, thank you for that. I hope you enjoyed listening to it as much as I enjoyed speaking it. Hopefully we've got a few questions that have come through, so let's get into some q and a for the rest of our time.
Georgina:
Hey Paul, we've had some lovely comments through and a few questions here. So let's start out, so what would a more productive New Zealand economy actually look like?
Paul:
Yeah, interesting question. Not like how our current economy looks and feels. I think economists have done quite a bit of work looking at productivity from a business perspective, from using firm level data sets. And it's given us quite a rich picture of what an economy with good productivity growth would look like. I think when I compare that picture to the New Zealand economy, we would clearly be more outward looking. We would be better connected internationally. We would have deep clusters of businesses that are engaged internationally in areas of strength that New Zealand has in global markets. So yeah, we would be deeply internationally integrated. We need to be because a small economy, so you need bigger global markets for firms to improve their scale and also to enhance competition, both of which are fundamental for improving productivity. And also if we were better connected internationally, that would work as that would allow technology, new technology to flow into the New Zealand economy.
But it's not sort of all just about that outward looking component, those sort of firms at the frontier of the New Zealand productivity distribution, we would also have more dynamic and competitive domestic markets. So there'd be more competition. I think currently firms in New Zealand, a lot of them operate in small insular domestic markets. So that would change productive firms in the economy would be able to grow unproductive firms would have to either lift their productivity performance, lift their game or exit and that would sort of free up their resources to flow to more productive areas in the economy. So that sort of more dynamic, more competitive domestic supply chain would be part of our outward facing comparative advantage. So it would all sort of be self self-reinforcing, I should say. We're a long way from that. That's not how the economy currently looks. The economy has to change for us to get to this place and it will look and feel quite different to what we've grown used to.
Georgina:
Thanks for that Paul. How do you interpret the recent revision of the GDP data considering the lags and monetary policy? Does it imply that the spot rate should be restrictive excuse, less restrictive?
Paul:
So yeah, end of last year we had very large revisions to GDPI sort of mentioned them at the beginning of the speech where we are not going to talk about the sort of monetary policy implications of those revisions, get to that in a few weeks. But my kind of sense, so we had stronger growth than previously measured over 2022 and 2023. And for me that's when I saw that I thought, well that's more consistent with what we were seeing in the bank at the time because at that time we were still talking a lot about non tradable inflation, domestically driven inflation in the economy and it was a little challenging squaring that with a very flat GDP track. So not too it makes more sense, but as I said, we'll get to the monetary policy impacts of that later next month. I should also say for me those big revisions is sort of highlighted the issue of poor data in the New Zealand economy, our economy is not particularly well measured.
And the point I usually make around that is that investing in our data, which is fundamental to getting policy, the cost of that is pretty minuscule when you compare it to the cost of us making a policy mistake because of dodgy data. And the other thing I'll add to this is that we are investing in other data sources here at the bank and we've got a lot of high frequency data that we're all across. So it's not all about GDP, but yeah, important data and would be better if it was a bit more stable in terms of smaller revisions.
Georgina:
Thanks Paul. Do you think that the economy is batting above or below long run potential output? What does the RBNZ define as the long run? What is the very long run?
Paul:
Well, currently we've got a negative output gap. So we are in a bit of a hole and that again, the GDP revisions really sort of highlighted that. So we are clearly batting below our potential output. And as I mentioned in the speech, we do see that growth picking up over the next couple of years very much from a cyclical perspective. So the economy finding its way out of that hole and getting back up to potential. And in terms of that's what we see long run growth as being, it's all about potential output as I sort of mentioned in the speech that determines our long run growth trajectory. And yes, we get business cycle volatility, one-off shocks that kind of knock the economy off that long run growth trajectory, but over time the economy tends to gravitate back to that potential output growth track.
Georgina:
Thanks, Paul. Investment into housing has been prioritised by a lot of Kiwis. That's been a good investment though, hasn't it? So why would that change now?
Paul:
Yeah, interesting question and a complex question. This one, my first speech is reserve bank governor over two years ago. We made the point that housing is no longer a one-way bet for various reasons. And I do think that has sort of come to pass. I do think capital gains in the housing market have become a bit harder to find, which from my perspective, I think this idea of trading houses among ourselves at ever increasing prices pretending that we're creating prosperity, I don't think that is a pathway to long run prosperity and wellbeing because younger people affordability comes into it. Not only is it an asset, but it's where people live. And I fully appreciate that for many New Zealanders housing is their main investment, but the sort of point of the speech at least is that if housing isn't going to provide those, that capital gain going forward because we are getting better at supplying houses for a bunch of reasons, then we need other profitable investments for people to save with. And I think we would get that with a productive, a more productive New Zealand economy, it would become more about equity and become more about businesses doing interesting things internationally and generating a strong return for New Zealanders in that way. Again, that's getting back to your first question. That's another thing that would look very different in a more productive New Zealand economy.
Georgina:
Thanks Paul. Are you annoyed that the productivity commission was wound up when it's obvious New Zealand still has a productivity problem?
Paul:
Interesting. I'm try and be a little diplomatic answering that question. Just for the record, everyone, like I worked at the productivity commission from when it began in 2011, I think it was for seven years to 2018. I was the director of the economics and research bit and it worked well because my tasks surrounded by an amazing team was to sort of build a narrative around why the New Zealand economy has productivity issues and doesn't perform that well. And I think we did that, we sort of laid out the economics along that, some of which found its way into the speech and then we had inquiry teams that were really digging down into aspects of that overall narrative from a public policy perspective. And I think the commission did some great work and I think a lot of that work is still relevant current, it's now being housed on the treasury website.
I hope public sector, public policy professionals dipping into that because our productivity issue hasn't gone away. As was clear from the speech, I do think the demise of the productivity commission, it does put the onus on other parts of the public sector to sort of pick up that narrative. And in that sense, I guess I'm indifferent as to what the institutional form of the public sector is, as long as we are talking about productivity and as long as we get on and fix it. So in the long run, hopefully the demise of the productivity commission won't matter to that kaupapa.
Georgina:
Thanks Paul. Bit of a long one here, but a good one. The analysis suggests that changes in productivity growth have had twice the impact of reductions in the global neutral rates since 2000. Global markets imply a higher neutral rate. When we look to long-term interest rates, what do you think the balance is likely to be between the influence of global rates versus productivity growth? Looking forward, is it likely that further falls in productivity growth will balance the influence of increasing global risk-free rates?
Paul:
Well, I mean that's quite a question. That is a long question and it's quite a, it's sort of asking how important are global factors in the well decline in the mutual interest rate, even though it's kind of blipped up a little bit over the last few. I'm actually going to take a pass on that question. We do have some amazing work coming out on the neutral interest rate and the drivers of the neutral interest rate that will weigh up exactly how important those different factors have been in driving changes in the neutral interest rate, be it the decline or the more recent pickup. So I think I'm going to leave it till we publish that work for whoever that was to get an insight into the relative importance of those various factors. So for us, just to reiterate that decline, it's all about global factors and in turn that's about lower productivity and ageing populations. And then domestically we've also had people living longer and weakening productivity growth, which has added downward pressure. But on the other hand side, New Zealand has had relatively strong population growth, which has tended to put upward pressure on the neutral interest rate. So in terms of how all that plays out and relative importance across all of those drivers, it is quite a technical question in a way and we'll no doubt, have a good crack at answer in it in this upcoming paper.
Georgina:
Looking forward to it, Paul. Thank you. Look, if we are not a rockstar economy now what happened?
Paul:
I don't think we've ever been a rockstar economy since the fifties kind of thing. I think that sort of quip was relevant to a cyclical period in New Zealand's economic history where we were performing well. And it's great from a cyclical perspective for the economy to be going well. I mean from a central bank perspective, you sort of want the economy at potential output with inflation at target. And if we get ahead of that, then that's inflation area and that that's our job is to sort of moderate those fluctuations, those business cycle fluctuations in the economy because that's how we get low and stable inflation. But in terms of New Zealand's long run performance, we haven't been a rockstar economy for decades. We did get a productivity surge in the mid to late nineties when the effects of reform in New Zealand in the eighties and the early nineties sort of kicked in and we were coming out of a huge recession in the early nineties, but it kind of faded away.
And our economic performance, to my mind at least has been, and you see it in the data, we have been declining in all sorts of metrics relative to the rest of the OECD. And I think it's really important that we do just sort of look around internationally to gauge our performance and what's possible. So I think in terms of New Zealand being a rockstar economy, there's been glimpses of it in the past, but I think if we play our cards right, not just regulation private sector as well and individuals, if we play our cards right, the best is yet to come.
Georgina:
Beautiful. Got time for one or two more for the neutral rate. The RBNZ has published and discussed shorter term and longer term versions. How has the RBNZ considered the different forms slash is there more of a view to refer to the long-term rate?
Paul:
Yeah, so we tend to the long term, this is how you go, we estimate the neutral interest rate using a bunch of techniques that typically estimate it in real terms. So inflation adjusted, that's the way to think about, it's the real interest rate that influences investment and influences savings. So the nominal interest rate adjusted for inflation, of course people we don't sort of think or economists do, but normal people don't sort of think in that way. So to go from that real rate to that long run, nominal neutral interest rate, we add on inflation expectations in 10 years time, which should be around two given the central bank on the job. So that's how we go from real to nominal. So we can adjust that real neutral interest rate by inflation expectations over the coming year or over the coming five years. So we can get a medium term view of neutral interest rate or a short term view of the neutral interest rate. And that's interesting from a monetary policy perspective in terms of whether or not the OCR is being expansionary or contractionary. But I would say the most important in terms of where it's going to drift to in time is that long run neutral nominal interest rate adjusted by 10 year inflation expectations. That's the sort of key one in terms of the long run dynamics of the OCR.
Georgina:
Great. Given our capital constraints and underperformance and exports, does this suggest that without changes to the dynamics that RBNZ anticipates growth will rely almost entirely on population growth?
Paul:
Not entirely. You would've seen in one of the earlier graphs, capital, we do invest as an economy. It's not that dire that we're all just sort of working with tools from the 1990s and capital from the 1990s. It's just that investment hasn't been fast enough to keep up with a rapidly growing population. So there's still investment going on. It's not just all driven by population growth. Although I would add, when I think about New Zealand's long run economic growth over recent decades, a lot of it has been about expanding the population mainly through migration as opposed to sort of natural increases. And a lot of it has been about house prices going up. And I would argue that our forecast for house prices in the November NPS was relatively modest and also inward migration has also fallen a long way compared to just a year ago.
So I do think those traditional drivers of growth, well first of all, I don't think they're optimal from a per capita perspective. We're very good at talking in per capita terms when it comes to medals at the Olympics. We're less good at thinking in per capita terms when it comes to our economy. But I would say those traditional drivers of growth in the New Zealand economy from a per capita perspective, haven't delivered as well as ideally they would. And I do think the period where they have been dominant is coming to an end, which is part of the reason why productivity has become a hot topic in New Zealand. It's sort of changed coming out of the pandemic. Where is growth going to come from in the New Zealand economy and productivity is the obvious answer. And yes, it's been incredibly difficult to lift our productivity and you see that in the data, but I think we understand why, and I think there are opportunities in front of us. I think we are a low productivity economy compared to the more advanced OECD economies. So there's a technological disconnect there. How are those guys managing to do it and can we be more like them in areas where we have competitive and comparative advantage globally? So yeah, we're very balanced in where we think growth is going to come from.
Georgina:
Thanks, Paul. That's all the time we've got for the questions today, so I'll pass it back to you to sign off.
Paul:
Thank you. Thank you George. And thanks everyone for those questions and thanks for tuning in. As I said, print version of the speech on the website. Really appreciate you coming along to this webinar. And yeah, we'll do it again soon and we'll see you on February 19th for the MPS. Ka kite.