Strong demand must be matched by growth on the supply side of the economy
The economy is heading into 2014 with a lot of momentum.
The rebuilding of Christchurch, Auckland's housing boom, surging net immigration and the most favourable terms of trade for 40 years are all boosting the demand side.
Sky-high business and consumer confidence reflects this.
But how long and strong the cyclical upswing will be depends on what happens to the supply side of the economy, on growth in its productive capacity underpinned by such factors as growth in jobs and productivity.
If demand is loping ahead in leaps and bounds but the economy's capacity to supply goods and services is just shuffling forward, all the excess demand will deliver is inflation and a blowout in the trade balance. That would be unsustainable and the Reserve Bank would need to rein in demand.
At this stage it does not look as if governor Graeme Wheeler will be brutally yanking the bit.
The bank estimates the economy's "speed limit" or potential growth rate - the rate consistent with full employment and quiescent inflation - will be about 2.5 per cent a year over the next couple of years, the strongest since before the recession.
It forecasts actual growth to run at 3 per cent next year before easing back to 2.3 per cent the year after as interest rates climb around 2 percentage points.
The drivers of that growth all come with some downside.
The cost of rebuilding and repairing large swathes of our second-largest city is estimated to be $40 billion, nearly half of which falls to overseas reinsurers.
It is a lot of work, not only for the construction sector but for manufacturing - the Reserve Bank reckons a 1 per cent increase in construction activity requires nearly a 0.4 per cent increase in manufacturing - and sundry service industries. But in the end all that investment is largely replacing wealth destroyed three years ago, not expanding the productive base.
And the bank will be watchful for signs - not evident yet - that rising construction costs will be the harbinger of wider inflation, as in the past.
The renewed house price inflation, running at an annual 15 per cent in Auckland and nearly 10 per cent nationwide, has a starting point of house prices and household debt levels already very high by historical standards relative to the incomes out of which mortgages have to be paid.
The glass-half-full view is that gravity will soon assert itself and this housing cycle will prove less extreme than the last one.
The glass-half-empty view is that a bubble mentality is taking hold, inviting the sort of grief the United States, Ireland and Spain have experienced in recent years when their property bubbles burst all over them.
The OECD estimates the house price-to-income ratio is 26 per cent above its long-term average, compared with 5 per cent below the long-term average for the OECD as a whole.
A key question for next year will therefore be how effective in mitigating that risk the Reserve Bank's experiment with regulating loan-to-value ratios, combined with rising interest rates, will be.
In addition to posing a risk to financial stability, house price inflation is liable to spill over, via the wealth effect and debt-fuelled consumption, into general inflation as it did in the 2000s.
Already household saving rates, which went in the black after the recession, have slipped back into negative territory with households spending more than their income.
Meanwhile the net flow of migrants has flipped from a net outflow in 2012 to a net gain of 20,000 in the year ended November. Annualised, the gain for the past six months is nearly 30,000.
However, this has been driven by an economic slowdown in Australia, our second-largest trading partner.
It will boost both the demand and supply sides, but the demand side first, especially in the housing market.
It is not just the Australian economy that New Zealand is out of sync with. We are expected to have one of the strongest growth rates among developed countries over the next couple of years.
And even though New Zealand's growth rate should continue to be broadly similar to that of the United States, the latter is arguably off a significantly lower base as measured by the proportion of working-age people who are employed.
So, while the US Federal Reserve announced last week that it intends to start scaling its bond purchases from the $1 trillion a year pace it has been running at, its forward guidance on interest rates remains very dovish.
The differential between New Zealand and US shorter-term rates can therefore be expected to widen as the Reserve Bank embarks on a tightening cycle next year, probably in March, which offers little prospect of relief from that quarter from an overvalued exchange rate.
Arguably more important for the exchange rate is the terms of trade - a measure of export prices relative to import prices - which is at its most favourable for 40 years, reflecting strong prices for exports. Historically rises and falls in the terms of trade explain most of the exchange rate's deviation from its long-term trend.
A high terms of trade boosts national income and the associated boost to the exchange rate ensures the benefits flow not only to farmers enjoying higher prices but to consumers by way of cheaper imports.
But even with the best terms of trade for 40 years the country has not been able to manage a trade surplus, though the deficit is narrowing.
The rebalancing of the economy from growth driven by domestic consumption to export-led growth, and to less reliance on importing the savings of foreigners to fund investment, has made some progress.
Finance Minister Bill English said last week that since mid-2009, the trough of the recession, the tradable sector has grown by around 11 per cent after stagnating between 2005 and 2009, while the non-tradable sector had grown by 6 per cent.
Continuing that rebalancing required ongoing fiscal prudence and microeconomic reform, he said. A lower exchange would also help.
Of the six recessions since the mid-1950s, 2008/09 was the second-worst in duration and severity, exceeded only by the one that followed the first oil shock in the mid-1970s.
The recovery has also been the second-slowest. It has nevertheless seen unemployment fall from a peak of 7.2 per cent in September last year to 6.2 per cent a year later.