NZ’s economic balancing act

New Zealand’s economy is in transition, moving from one with overstimulated domestic demand to one where a rapid withdrawal of stimulus is required to tame the inflation beast.

On one side, the Reserve Bank of New Zealand faces the risk of oversteering and engineering a hard landing for economic activity; on the other, the risk of inflation pressures continuing to spiral.

At some point in the not-too-distant future, the official cash rate will be back at a level where these risks are a little more balanced, and decisions will be more difficult.

Overall, ANZ Research expects New Zealand growth in 2022 come in close to trend, but below trend in 2023 and 2024. Risks are skewed to the downside.

Drivers

There is a long list of key drivers of economic momentum in NZ either currently transitioning or expected to transition in the short to medium term. Each carries additional risks and uncertainties (such as timing, magnitude or flow-on economic impacts) that can cause economic outcomes to vary significantly.

While lockdown-induced volatility is hopefully a thing of the past, there remains considerable uncertainty in the economic outlook as NZ moves toward the new normal.

COVID-19 developments loom as a key factor. Any further serious outbreaks could impact border settings and therefore net migration and services export, including tourism and education.

The evolution of labour supply relative to demand will continue to be closely watched. Open borders are both a risk and an opportunity for the former; slowing activity and monetary tightening are a risk to the latter.

Global supply chain bottlenecks and materials shortages, and the impact on CPI inflation will also play a role. The composition of global demand as COVID restrictions ease and households start normalising their consumption back towards services will also be significant.

The pace and degree to which house prices are likely to fall, and how this will impact broader economic outcomes, is another factor. Household spending in a uniquely difficult environment will also be a driver.

And finally, the impact – in both magnitude and timing - of monetary tightening, domestically and abroad. It’s likely we are yet to see the full impacts of the current tightening cycle.

That’s a long, and not even exhaustive, list of turning points. If anything, global inflation risks have intensified over the past few months, but frontloaded rate hikes by the RBNZ have mitigated domestic inflation risks.

Many other central banks across the globe are now underway with their tightening cycle too, and ANZ Research fully expects them to tame inflation in time. The question is, how much tightening will it take, and how much economic pain will it require?

Downbeat

Some NZ economic indicators are looking rather downbeat, but COVID-volatility is making it hard to separate the noise from the signal. Near term, gross domestic product data will be noisy. Lockdown impacts partially unwound over the final quarter of calendar 2021 and should continue unwinding through the omicron-ravaged start to 2022. However, it’s possible omicron pushes some of this bounce into the second quarter.

Provided NZ manages to avoid lockdowns in 2022, the GDP data should settle down over the second half of the year. But for now, a better steer for economic momentum is likely found elsewhere – and there are plenty of indicators suggesting that is slipping.

ANZ’s NZ consumer confidence survey tends to provide a very good steer on momentum in retail activity, which in turn, tends to provide a very good steer on overall domestic demand. The ‘good-time-to-buy-a-major-household-item-indicator’ has been at levels not seen since the global financial crisis - a period retailers do not remember fondly.

ANZ’s business outlook survey suggests a slowdown in residential construction, although building consents continue to push record highs, largely in multi-unit dwellings. While that suggests the construction pipeline is full, rapid building cost inflation, construction delays, difficulty achieving presales as house sales and prices fall could very well see some of these consented projects scrapped.

There are other reasons to think tougher times lie ahead. International tourism isn’t expected to start picking up meaningfully until the 2022-23 summer.

Conditions for exporters are tough. Key export commodity prices are elevated due to tight global supplies, but they are slipping as the willingness and ability of global consumers to pay top dollar for NZ produce is reduced.

But output prices are only part of the story. Difficulty getting product to market and finding workers for farms and orchards are weighing on agricultural production. Plus, the price of fertiliser has gone through the roof.

Households are going backwards financially as inflation outpaces income growth. ANZ Research’s forecast for real wage growth to return to positive territory by the end of the year will hopefully help change the mood among consumers and facilitate the soft landing in the economy we’re all hoping for.

But that’s a mixed blessing for the RBNZ, who are quite rightly concerned about the possibility of a wage-price spiral developing. Any further impetus to CPI inflation from fiscal settings will need to be met with a higher-than-otherwise cash rate.

Change

The economic outlook is likely to feel very different for many households then recent times. Private consumption is expected to slip as a share of the real economy, as the demand impulse from the labour market reaches its limits and high inflation, higher interest rates and a slowing housing market bite.

Investment is another key driver of domestic demand, and one that tends to be very sensitive to interest rates. All up, we foresee both residential investment and other investment shrinking only mildly as a share of GDP, but a harder landing in housing than expected would very likely see investment underperform.

Net exports should improve, with services exports hopefully well on the road to recovery by the end of 2022. However, it will likely take a couple of seasons before tourism is well and truly back on its feet.

Services imports are expected to recover faster, and there’s pent-up demand to escape the NZ winter over coming months. On the goods side, export volumes are expected to struggle as agricultural production faces headwinds, despite solid prices. Imports are expected to remain strong in the near term, reflecting the cyclically solid domestic demand pulse, but as household demand slows, so too will goods imports.

Inflation will ease. While there are some significant inflation pressures stemming from global developments, the ongoing intensification in domestic inflation pressures is the primary concern for the RBNZ.

ANZ Research expect rate hikes - supported by the tightening underway globally - will successfully take the heat out of inflation in time. Tradable inflation will slow alongside global developments but shaking non-tradeable (domestic) inflation will require a loosening in the labour market and a housing slowdown. That’s a longer-term project.

Having hiked 50 basis points in April, the RBNZ is now well and truly off and running, with 125 basis points of hikes already under its belt. Some global central banks are only just getting started.

ANZ Research expects a second 50 basis point hike in May, taking the official cash rate to 2 per cet. Based on the RBNZ’s current thinking that’s a bit of a magic number for the OCR. It’s the RBNZ’s most recently published estimate of the ‘neutral’ OCR – consistent with stable, close-to-target inflation over the medium term.

The RBNZ’s strategy currently appears to be to reach neutral quickly, and then take it more gently from there, given the lags with which monetary policy operates.

Any change in the estimate of at what interest rate the foot moves from the accelerator to the brake will have consequences for the likelihood of a third hike in July. To really deliver a knockout punch to inflation, ANZ Research thinks the RBNZ will need to take the OCR into contractionary territory – that is, above neutral.

They expect to see a series of back-to-back 25 basis-point hikes taking the OCR to 3.5 per cent by April 2023.

ANZ Research has extended its expectation for how long the OCR might need to stay at 3.5 per cent. Previously, the expectation was for the OCR to gradually normalise from early 2024, but that’s now expected to occur in the second half of that year.

It’s hard to overstate the uncertainty about where the OCR will peak and how long it might need to stay there. On the one hand, getting on top of 7 per cent inflation with ‘just’ a 3.5 per cent OCR would be quite the achievement, given the OCR typically peaks well above inflation. On the other, the RBNZ is hiking amid an already rapidly weakening housing market, and in that context, it’ll be impressive if the wheels don’t fall off before the OCR gets that far.

Signs

Right now, the inflation-spiral risk is dominating, and that speaks to another 50-pointer this month. Markets are toying with another 50 basis-point hike in July, and while that can’t be ruled out, ANZ Research thinks the signs will be clear monetary tightening is getting some traction by then.

The important things for which to keep an eye out before July are evidence household and business inflation expectations have peaked and beginning to turn, evidence global inflationary forces are no longer intensifying, evidence the degree of unmet labour demand is easing, evidence the housing market is slowing, and evidence higher rates are taking enough heat out of the domestic demand impulse to reduce capacity pressures.

All up, the rebalancing act that the RBNZ and other central banks are currently performing is riddled with risks and uncertainties. But the one thing we can be sure of is they will be successful in taming inflation. It’s just a question of how high rates need to go - and for how long.

Miles Workman is a Senior Economist at ANZ NZ

This story is an edited version of the ANZ Research report, “NZ Economic Outlook: rebalancing act”, published May 10, 2022