State of the nation

Looking back, 2022 was certainly a year of economic surprises – but fairly consistent ones. With inflationary pressures growing quickly, the Reserve Bank of New Zealand (RBNZ) raised the Official Cash Rate at unprecedented speed from a 0.25% starting point at the start of October 2021 to 4.75% on 22 February 2022, with more to come.

With inflation seemingly stuck around the 7% mark, RBNZ Governor Adrian Orr intends to keep on raising rates until he’s confident inflation is sustainably on the way back down to the 1-3% target. In November, he admitted he is aiming to “deliberately engineer” a recession to lower inflation, and there’s no doubt that he has the tools to bring that about, albeit his primary tool is more of a sledgehammer than a surgeon’s scalpel. But the upshot is, a slowdown of some shape or form does indeed seem a likely outcome in 2023. What is less certain, is how much of a slowdown is needed to bring inflation down, in a world where we just keep getting hit with inflationary shocks, the cyclone just being the latest one.

In our forecast, higher interest rates result in weaker residential construction, consumption and business investment – and along with all of that, weaker employment. There are already signs that this is starting to happen. For example, real retail sales fell in the last three months of this year, and job ads are clearly past their peak.

Offsetting the impact of higher interest rates somewhat is the quicker-than-expected recovery in international tourism, which is boosting activity over the summer. That’s mixed news: the RBNZ noted it could be very inflationary given capacity constraints in the sector (particularly labour shortages), but on the other hand it’s very welcome from an ‘earning our keep’ point of view. New Zealand is currently running both a large trade and current account deficit due to both strong imports (e.g. of consumption goods) and fiscal deficits. At some stage we need to start living within our means again.

Necessary it may be; fun it is not. There’s a pretty broad consensus that 2023 is going to be a tougher year economically, with more households rolling over onto sharply higher mortgage rates, house prices falling further, discretionary spending tightening up, and the unemployment rate rising.

But there’s enormous uncertainty regarding how quickly this will manifest, how dramatic the slowdown will be, and how rapidly it will bring down core inflation. The unwelcome arrival of Cyclone Gabrielle has (literally) muddied the waters further. The impacts will disrupt economic activity in the short run, but boost activity over the medium term as the rebuild effort gets underway. It will also, unfortunately, be inflationary. In the near term, things like fresh food, cars and rents will come under pressure; in the medium term construction cost inflation is likely to remain elevated for longer as we attempt to rebuild damaged housing and infrastructure while also maintaining business-as-usual. All up, while the RBNZ will “look through” as much of the impacts it can, if it looks like inflation is going to take an unacceptably long time to come down, whether due to the cyclone or some other cause, the Official Cash Rate will need to go higher still. We see risks tilted to the upside around the 5.25% OCR peak we are forecasting.

Ongoing normalisation of supply chains and weaker consumer demand should see goods inflation wane, helped along in our forecasts by lower oil prices and a recovering NZD. However, none of those things are a given, and the latter two are frankly a bit of a lottery from where the Reserve Bank sits. And the outlook for wage growth and inflation expectations – key drivers of ‘sticky’ services and core inflation – is far murkier.

Wage growth has escalated rapidly, and inflation expectations appear stuck at high levels: around 6% in the ANZ Business Outlook survey and 5% amongst consumers. The RBNZ now translates short-term inflation expectations directly into its estimate of how stimulatory or contractionary a given level of the OCR is, and therefore how high the OCR needs to go.

How sticky wage inflation will go depends not only on inflation expectations, but also, most crucially, the outlook for unemployment. The RBNZ is forecasting unemployment to rise quickly, starting immediately. Certainly job ads and anecdote suggest the labour market has come off the boil, it’s still boiling hot. The proportion of firms who reported in December that labour is the factor constraining their expansion is not far off a record high, and the summer tourism boom is providing a surge of employment opportunities. The RBNZ needs to get the labour market to a place where firms don’t feel they have to offer very large pay increases in order to retain their staff, and it’s not clear we’re there yet.

With roughly half of mortgages set to roll over onto much higher mortgage rates in the next 12 months, the RBNZ is certainly going to suck more money out of borrowers’ pockets. But only a third of households have a mortgage, and in the meantime, strong wage rises are replenishing those pockets. The ratio of household debt to disposable income has actually held very steady in recent years, despite the largest housing boom New Zealand has ever seen. Household debt isn’t the firm cap on how high the OCR can go that you might intuitively expect.

While the fate of the labour market is the clincher for the interest rate outlook, one can’t discuss the year ahead without discussing the housing market. House prices are already more than 15% off their November 2021 peak, and on their way to a cumulative 22% fall, by our forecast. Adjusted for strong wage growth, that would imply real house prices falling by around a third. That’s hardly chump change, but the fall in house prices has so far been very orderly. Very few homeowners are as yet in distress or negative equity, and very few sellers are in a must-sell situation because unemployment is so low. All up, it’s a case of ‘so far so good’. Real house prices have to come down, and so far the mix of nominal house price falls and wage growth that’s bringing that about has been very manageable in aggregate. But of course, every average hides a thousand stories.

Stepping back, 2023 is shaping up as a bumpy one. How hard the landing will be, its timing, and how fast it will solve the inflation problem are all unclear, with a wide range of views out there. The same debate is being had in numerous countries throughout the world. And that’s all assuming no more big surprises – there will no doubt be some of those along the way. There are big challenges, including enormous questions about how we can afford to build the resilience required for a changing climate. But it shouldn’t be forgotten that the New Zealand economy has a lot going for it; fiscal headroom, relatively good insulation from global energy challenges, and an export sector centred on food, the relative price of which has been rising for two decades and seems likely to continue to do so.