5:30 am The Auckland economy is heading into a sweet spot as the region benefits from low interest rates and a low exchange rate with the Australian dollar, says a leading economist.

The recession hit Auckland earlier and harder than New Zealand as a whole, but it was already out-performing the rest of the country in terms of economic activity through the last three quarters of 2010, said Goldman Sachs economist Philip Borkin.

Auckland is especially sensitive to financial conditions, which are at their most stimulatory since July 2009.

Mr Borkin said the city’s economy should be growing by between 3 and 3.5 per cent by the end of the year.

Growth over the entire year could average around 2.5 per cent, compared with the 1.5 he expects for the country as a whole, which is more optimistic than the consensus 1.1 per cent.

By contrast, he said, Canterbury had been hit by the February earthquake, Wellington faced fiscal belt-tightening and, while rural regions might start to benefit from record-high commodity prices, farmers still appeared focused on debt reduction.

The out-performance is most notable in the housing market, with annual house price growth running at 1.8 per cent in Auckland but falling by 1.8 per cent nationwide.

Mr Borkin estimated that demand for housing in Auckland was growing by around 9000 homes a year while new supply, as reflected in dwelling consents issued, was just 3600.

He said that while net immigration was falling, there might be some internal migration from Christchurch.

“However, we are not expecting Auckland house prices to suddenly race away. Affordability remains an issue. But it is quite possible house prices could be rising by around 5 per cent a year by the end of the year.”

That would make people feel more comfortable about their financial situations and boost consumer spending, Mr Borkin said.

When combined with a boost from the Rugby World Cup, he estimated that would underpin growth in retail sales in Auckland of 2.1 per cent over 2011 in real terms, compared with just 1 per cent nationally.

But he cautioned that if demographics were driving Auckland house price out-performance, then rental inflation would also be likely to rise.

“Higher rents, all else being equal, leave less cash for discretionary spending.”

Another risk to this relatively sunny outlook is that the Reserve Bank might raise the official cash rate sooner than the March quarter, which Mr Borkin expects, as do a majority of market economists.

Yet another risk is that households remain cautious. “It has been our long-held belief that once house prices showed firmer signs of stabilisation, consumers would feel a little more comfortable boosting spending levels,” he said.

“However, there is the possibility that there has been a permanent altering in household behaviour, and caution and balance-sheet repair prevail for a little longer yet.”

A two-paced economy, even if only for a short period, makes the Reserve Bank’s job more difficult. The official cash rate is a one-size-fits-all type of instrument.

Mr Borkin said the bank would have to set monetary policy on a national basis, suggesting it would be the new year before it raised rates.

… but watch out for higher interest rates

New Zealand’s economic recovery may accelerate in the second half of the year amid rebuilding after the Christchurch earthquake, increasing the chance of higher interest rates, according to AMP Capital Investors.

“It may be a situation where you have a flat first half of the year and then the rebuilding-recovery story takes place in the second half,” said senior economist Bob Cunneen.

Mr Cunneen forecast the economy might expand about 1.5 per cent this year, faster than the 1.3 per cent Reserve Bank Governor Alan Bollard forecast last month. The central bank cut borrowing costs to a record 2.5 per cent on March 10 to bolster confidence after the February 22 earthquake.

An economic rebound may prompt Dr Bollard to raise interest rates late this year which, along with rising commodity prices, may buoy demand for the currency, pushing it to between US80c and US85c.

“You need the commodities story to stay intact, but you need monetary policy to start to tighten,” Mr Cunneen said. For that to happen, “the governor has to take the view that economic activity is going to be accelerating and that’s probably not likely until the end of this year”.

- Bloomberg