State of the nation, December 2024

The Reserve Bank (RBNZ) is further along the path of monetary easing than most, reflecting that the economy has been soft, and inflation pressures are in retreat with headline inflation close to the target midpoint. With the Official Cash Rate closing out the year at 4.25%, 125bp below its peak, and several more cuts next year priced into wholesale interest rates, the big question is how vigorously the economy will respond.

While changes in interest rates take time to feed through, particularly given the preponderance of fixed-rate mortgages in New Zealand, early signs are promising.

The housing market has taken note. Sales have recovered to more average levels and the proportion of house, still fairly modest in the context of how far house prices have fallen since their 2021 peak, but considerably more supportive for consumption than flat-to-falling prices.

As regards to the broader economy, firms’ expectations for their own activity (as well as investment, employment and profitability) a year ahead have sky-rocketed, and their estimates of activity in the past month have also lifted, albeit less dramatically, suggesting stronger GDP growth ahead. The lift makes sense; this slowdown was deliberately engineered by the RBNZ via higher interest rates, so lower interest rates should be an effective cure; albeit not an instant one.

For now, though, the economy remains soft, with spare capacity building, including in the labour market. The unemployment rate hasn’t risen quite as quickly as the Reserve Bank expected, but at 4.8%, it is well off its lows, and all indicators suggest that wage pressure is very modest, and likely to remain so. That is giving the RBNZ confidence that there is sufficient pipeline domestic disinflation to allow them to look through the stickier elements that are slowing progress on this front.

These sticky elements (local authority rates, insurance, rents, and some indexed taxes) are responsible for around half of non-tradable inflation currently. Construction costs and wage growth dominate the remainder, and the RBNZ is confident that they are winning these battles. Steady falls in core inflation and well-behaved inflation expectations also provide a strong degree of comfort.

We therefore expect the RBNZ to continue its easing cycle next year, though to a limited extent given early signs of economic recovery and the need to maintain a degree of caution. Although they recently changed their assumption about how firms set their prices, assuming firms will ‘forget’ the high-inflation period more quickly, cost pressures have been a little sticky. The proportion of firms reporting rising costs in our Business Outlook survey is still higher than pre-COVID, though the expected extent of these cost rises has retreated steadily.

Firms have bigger problems than costs currently, however. As monetary policy tightening bit and the economy cooled, the most pressing problems have evolved from costs, wages and labour shortages to low turnover, competition and cashflow – problems that make it harder to pass higher costs through into prices and make it less likely that firms will invest or employ. Against that backdrop, it would take a lot to shake the RBNZ’s confidence that domestic inflation is set to steadily fall to closer to the 3% mark that has historically been associated with headline CPI inflation sustainably around target.

For some firms, the recovery can’t – or won’t – come quick enough. The retail and construction sectors have been particularly hard hit, having had large booms during the period during which the economy was overstimulated, and now experiencing the symmetrical bust. The services sector has been on a smaller rollercoaster but remains in a dip. Manufacturing has been hit by the slowdown in construction and consumer demand, with the PMI well under par, though like a wide swathe of high-frequency activity indicators, also well off its June low. Overall business failures have risen, but remain a fraction of what was seen in the recession following the Global Financial Crisis, given balance sheets are in relatively robust shape in aggregate and there is no credit crunch.

Households, too, are in aggregate in relatively robust shape in balance sheet terms. The average hides a lot, and rising unemployment and interest rates have both taken a significant toll on some households. But given New Zealand had the biggest housing bubble in the world during COVID times, it’s fair to say things could have been worse. High wage inflation, while not ‘real’, insofar as the bulk of it did not represent an increase in real purchasing power, did deflate away some of the increase in debt associated with the housing boom. While mortgage rates shot through the levels banks had tested households would be able to cope with, incomes also grew much more than banks had assumed. And in aggregate – though of course not for every household – that was a powerful offset that has meant financial stability has not been a concern, and a prolonged period of balance sheet repair is not required.

Turning to fiscal policy, job losses in the core public service are casting a dark shadow over the city of Wellington but are less important in the national picture. The degree of prudence implied by the May Budget is considerable, and with revenue threatening to undershoot projections, a degree of slippage in terms of the timing of a return to fiscal surplus appears likely at the Half-Year Update.

While the pieces are in place for a cyclical upswing in the economy, structural challenges remain. Productivity remains dire, and the recent strong wave of migration was skewed to lower skilled workers. Local government balance sheets are going to struggle to support the degree of infrastructure spending required. The health system requires massive investment to cope with the looming wave of ageing boomers. Climate change will make it challenging to grow primary sector export volumes, and we are price takers for the vast majority of our exports. Australia continues to pull ahead in terms of real wages, making it difficult to hang onto talent. The current account deficit is still very wide at 6.7% of GDP, and a credit rating downgrade could be the ultimate outcome. Some pretty smart policy choices are going to be needed to ensure the economy can thrive in a more divided world.

But here and now, firms and households just want to know that better times lie ahead. With interest rates coming down, dairy prices rising, the housing market showing signs of life, and activity indicators on the up, it’s looking like a merrier Christmas than seemed plausible a few months ago. We’ll take that.