State of the nation, July 2024

The New Zealand economy is looking decidedly soggy with the lagged impacts of the Reserve Bank’s rapid lifting of the Official Cash Rate having broadened through the whole economy. Rate-sensitive sectors such as the housing market, durables retail, commercial property and residential construction slowed first, but there is now no corner of the economy left untouched.

It hasn’t been all doom and gloom. The tourism recovery has been a real bright spot, for all that it has been incomplete; the lagged impacts of expansionary fiscal policy are only now running out of puff; and the net migration surge this year has eased labour shortages across the economy. But it’s tough going out there. Unemployment is rising, and a wide swathe of high-frequency activity releases including the Performance of Manufacturing Index, the Performance of Services Index, and the ANZ Truckometer have all rolled over in recent months. Housing market activity and job ads have slowed further too. GDP data for the June quarter could make for grim reading. 

Of course, a marked slowdown was the Reserve Bank’s plan, as history suggests that economies that take their medicine and deal to inflation problems promptly do better in the long run. And it’s also worth noting that spending more than we collectively earned as we did during the COVID era was never going to be sustainable, as highlighted by the blow-out in the current account deficit. Gravity was always going to come calling. But at the same time, the RBNZ has no incentive nor desire to cause a harder landing than necessary. The lags with which interest rates impact the economy mean the risks of undercooking and overdoing it need to be constantly weighed up, and the silver lining of the current pain is that rate cuts will come sooner than otherwise. Most forecasters are now expecting OCR cuts this year, and fixed mortgage rates are already falling. It’s very unlikely to see the economy turn on a dime, but there’s light at the end of the tunnel.

The housing market has softened in recent months, with a gulf between buyer and seller expectations leading to a very large number of unsold houses on the market. This is putting house prices under renewed downward pressure. However, it has been a very orderly adjustment since the late-2021 peak, with forced sales very rare. We are forecasting house prices to end the year at much the same level they ended 2023. Relative to incomes, house prices are now back around pre-COVID (March 2020) levels, and mortgage rate falls will further improve affordability for first home buyers, though no one could call getting on the housing ladder remotely easy. In nominal terms, house prices are still more than 20% higher than pre-COVID, meaning relatively few homeowners are in a negative equity position. 

Unsurprisingly, in an environment of flat to falling house prices and still-high interest rates, the construction sector is very pessimistic about the outlook for building activity. We expect a prolonged slowdown in residential investment after what was a spectacular boom during the COVID era. Construction costs have a pretty hefty weight in the CPI, and this is all part of the RBNZ’s plan.

Both anecdotes and business surveys confirm that firms across most sectors are finding the environment challenging, dampening the outlook for both investment and employment. Households are being far more cautious with their spending as job security deteriorates, and the retail and hospitality sectors are doing it particularly tough. Agriculture and forestry exports are facing headwinds from the slowdown in China’s economy, and geopolitical and climate risks are hanging over the medium-term outlook. The recovery in inbound tourism has run out of steam given the persistent absence of visitors from China and cooling global growth. A strong net export recovery is required to help rebalance New Zealand’s external accounts – if the export sector can’t deliver, more of the adjustment will have to come through importing less. The long-term outlook remains bright, given New Zealand’s excellent reputation for producing quality foodstuffs in a world facing increasing food supply challenges, but it’s a difficult point in the cycle, particularly for the sheep and forestry sectors.

Annual consumer price inflation has fallen from over 7% in mid-2022 to 3.3% two years later. That’s in line with what the Reserve Bank expected when they stopped hiking the Official Cash Rate (OCR) in May 2023. The details of CPI inflation aren’t quite the slam dunk the headline implies, insofar as much of the fall has come via inflation in tradable goods, which are heavily influenced by the exchange rate, shipping costs, and global commodity prices, especially oil. That type of inflation is running at just 0.3% y/y, but the RBNZ can’t take a great deal of credit for it, nor trust it to stay so benign. Prices of non-tradable goods and services (things that can’t be put on a boat or a plane, nor sent through the internet, with a haircut being the classic example) have a tighter relationship to whether the economy has been running hot or cold, and wage growth. That type of inflation hasn’t fallen nearly as much as the RBNZ expected it to. Non-tradable inflation in the June quarter was 5.4%, whereas back in May last year the RBNZ estimated it would have fallen to 4.1% by now. And inflation in some prices, like rents, rates, and insurance, is set to stay high for a while yet. Nonetheless, recent data means the RBNZ will have more confidence that things are now on track in the big picture, paving the way for an easing in the OCR this year.

The Reserve Bank has been very up front about the fact that the price of getting inflation back down to target was a recession. It’s been painful, but it’s working. In terms of where to from here, relief on the interest rate front may lighten the mood, but it will take time to feed through to people’s pockets given the preponderance of fixed mortgages. And in the meantime, job security is likely to get worse before it gets better. We expect only a very gradual recovery from here with unemployment continuing to lift over the coming year. 

But on the plus side, we expect CPI inflation to be back in the 1-3% target band in the next read, and back at the 2% band by the end of next year. High inflation has had a chilling impact on consumer confidence in recent years. The medicine to cure it has been bitter, but the good news is that it has worked, hopefully laying the groundwork for a more sustainable upswing in the years ahead.