Overheated economy is operating unsustainably

The stimulus applied to the New Zealand economy to combat COVID-19 has created unsustainably strong growth, demonstrated by rampant household spending, an overinflated housing market, and a rapidly tightening labour market. These pressures are even more concerning given disruptions to supply chains and the restrictions on foreign workers due to the closed borders. Tighter monetary policy is needed to slow economic growth to a more sustainable rate, which could mean GDP growth averaging just 1.2%pa between 2022 and 2026. Strap yourself in for an expansive overview of the economy, with lots of moving parts making us question how long the party goes on for.

New Zealand’s successful public health response to COVID-19 has laid the groundwork for the rebound in economic activity since the original lockdown in the June 2020 quarter. The spectacular nature of the recovery has been driven by the massive fiscal and monetary stimulus implemented in the face of the pandemic. Plunging interest rates and billions of dollars of government spending have ultimately flowed through into big increases in households’ discretionary spending. Of course, that outcome was exactly what was aimed for. All the stimulus supplied was designed to keep the engine running, make sure households had money to spend, and bring forward future spending by making credit cheap.

Stimulus of the magnitude we have seen would have been appropriate if New Zealand’s health outcomes had had been closer to the ones seen in the UK, where the country has been in and out of lockdowns throughout the last year. But with the benefit of hindsight, last year’s rush to stimulate the economy now looks to be well overdone given the general long-term absence of COVID-19 in New Zealand. Many businesses have also shown a remarkable ability to adapt and pivot their operations, helping to reduce the fall-out from the border closures – even in the tourism sector and most heavily affected regional areas.

That’s not to say that decision makers’ response to COVID-19 was wrong – without the substantial support we might not find ourselves in the same strong position. But the level of support now appears to be overheating the economy, and it’s important to consider how to unwind the support.

In terms of household demand, consumers might simply be making up for the enforced hiatus in spending during the second quarter of last year. If that is the case, then the outsized result for the March 2021 quarter has filled in only about 35-40% of that hole, and we could still have another 4-6 months of higher-than-normal spending to come through yet.

There has also been a diversion of money, otherwise earmarked for international holidays, to domestic spending given the border closures. During the last year, New Zealand resident spending overseas has been down $4.5b from the previous 12 months, with much of those funds instead being spent on domestic holidays, homewares and DIY, and big-ticket items such as cars and boats.

Whatever the case, growth in household spending looks set to threaten double digits this year (see Graph 1). The risk to this forecast is perhaps on the downside, if March’s very strong result proves to be a flash in the pan. However, electronic card spending data from MBIE suggests that growth has strengthened further since the March quarter.

Graph 1

One of the logical outcomes of buoyant demand conditions is potentially higher inflation. Two key points express this expectation for higher costs. Firstly, any cost pressures that are being experienced by businesses are more likely to get passed on when demand is strong. Secondly, if customers are streaming in the door and your business is already hitting capacity constraints, firms will often seize the opportunity to fatten their profit margins.

With more money out there, there’s more to spend on goods and services. But there’s also a more limited supply of goods and services, due to supply issues of goods and labour and because demand has increased more rapidly than supply. In this instance, prices are bid up as people are willing to pay more to secure the good or service that is harder to come by.

We have lifted our inflation expectations substantially. We now expect that the New Zealand economy is now facing its most inflationary environment since before the Global Financial Crisis, and inflation will spike towards, and possibly over, 3.0%pa this year (see Graph 2). Several supply-side factors are coming together to create a perfect storm of cost pressures at the same time as demand is strong.

Graph 2

Arguably the most high-profile and unusual factor is disruption to international shipping. COVID-19 has resulted in ships and containers being out of position and significant changes to the trade flows that have normally occurred. There are widespread reports that container costs for shipping goods to New Zealand have risen to between two and six times their pre-COVID levels.

New Zealand’s COVID-free status has also made it less attractive for shipping companies to travel here, given the additional infection prevention protocols and slower processing at our ports. These delays and reduced capacity have weighed on imports throughout much of the last year and contributed to shortages of some products in New Zealand. But there is increasing evidence that exporters are now experiencing issues with getting their products to market as well, with increased processing times meaning that ships are liable to cancel planned stops at one or more of our ports at short notice.

It is unclear when this situation will improve or be resolved, but it looks likely to stretch into 2022 given the relatively slow roll-out of the COVID-19 vaccine in New Zealand. Furthermore, the recovering global economy is likely to cause further demand stresses in the shipping industry in the short term.

Labour and skill shortages have progressively become more widespread throughout the last six months. Responses to the NZIER’s latest Quarterly Survey of Business Opinion show that getting either skilled or unskilled labour is the most difficult on record, with data stretching back to 1975 (see Graph 3). A raft of other employment, overtime, and staff turnover indicators from the survey show the labour supply is not keeping pace with firms’ demand for workers.

Graph 3

The tightening labour market is increasing wage pressures as businesses are forced to compete to attract and retain staff. Although this squeeze is not being felt evenly across the economy, it has spread progressively from booming industries such as construction and is becoming more prevalent as the unemployment rate tracks downwards.

Arguably the biggest issue for employers is that the safety valve of sourcing workers from offshore is currently not available. For areas as diverse as construction, aged care, transport, and agriculture, the lack of workers is limiting activity and firms’ ability to grow. Other industries that have typically relied on a relatively mobile workforce of people from overseas, including horticulture and parts of the retail and hospitality sectors, are also struggling to attract Kiwis to fill vacant roles.

The government has provided very few opportunities for workers to be brought in from offshore through managed isolation and quarantine (MIQ). The government’s reluctance to utilise the space in MIQ freed up by the Trans-Tasman bubble is consistent with its desire for businesses to be more focused on employing New Zealanders, keeping net migration lower over the medium term than it was prior to the pandemic. However, this approach also suggests a lack of responsiveness to the economy’s current needs and reflects an isolationist approach that has been exacerbated by the government’s COVID-19 elimination strategy.

The opening of the Trans-Tasman bubble also creates risks for the supply of labour. Net migration flows between New Zealand and Australia have typically been influenced by the relative economic and labour market performance of the two countries. With the Australian unemployment rate having dipped from 6.9% to 5.1% since October last year, the potential draw for workers to head over to Australia is increasing. Those pressures are exacerbated by relative incomes and the relative cost of living (particularly housing), which are both probably more attractive in Australia.

We expect wage pressures to build throughout 2021 as employment continues to climb and growth in the working age population remains constrained. A more rapid decline in the unemployment rate than we are forecasting would see labour costs accelerate faster than our current projections.

We have already mentioned in passing the role that the world economy’s recovery is playing in terms of shipping disruptions and higher freight costs. But the globe’s post-COVID rebound is leading to other inflationary pressures as well.

Graph 4 shows US inflation surging to a 13-year high of 4.9%pa in May, with the CPI climbing 2.0% in the last three months alone. Closer inspection shows that the pick-up is not just being driven by food or energy costs, to which the Federal Reserve is typically less responsive. US inflation excluding these components is at a 29-year high of 3.8%pa.

Graph 4

These increases are symptomatic of more widespread increases in commodity prices, reflecting a mix of higher shipping costs, disrupted supply due to COVID-19 restrictions in supplying countries, and improving demand conditions as the vaccine is rolled out, particularly in developed nations. Brent oil prices are now at their highest level since 2018, and MBIE’s latest data shows that retail prices for diesel in New Zealand have lifted 24% over the last 12 months, with petrol prices having risen 17%.

Since the Global Financial Crisis, concerns about resurgent international inflation due to the massive monetary and fiscal stimulus undertaken by the US and other countries have proven to be unfounded. Instead, China’s expanding manufacturing sector kept inflation in check during the 2010s thanks to increasing economies of scale and falling production costs.

However, it is less certain that this trend will continue throughout coming years. China is starting to pay more attention to environmental outcomes and seems less willing to pursue economic growth in such an unfettered fashion. For example, the substantial spike in steel prices this year has been accompanied by the Chinese government rolling out production restrictions as it attempts to reduce carbon emissions, other pollutants, and energy consumption. If this kind of action is repeated across other industries, it will ultimately restrict the supply of goods coming out of China and potentially lead to more inflation over the medium term.

Rising petrol and diesel costs are not the only energy prices causing concern within New Zealand. Wholesale electricity prices in April were sitting around six times the level they were a year earlier. Prior to 2021, the average monthly wholesale price had been above 20c/kWh five times since 1997. However, prices have now been above this level for the last five months consecutively. The futures market suggests that prices will ease during the second half of this year but, even by 2024, they are not expected to have fallen to the levels that prevailed as recently as November last year (see Graph 5).

Graph 5

Several major electricity users have cut their electricity consumption and, consequently, their production output levels in response to the high prices and potential shortages of power. These moves represent a constraint on economic growth. The high electricity prices also threaten to flow through into higher prices for other goods and services, as well as directly affecting households as retail electricity prices come up for review.

The upshot of this demand and supply imbalance is that the fiscal and monetary stimulus that seemed so necessary a year ago now clearly needs to be scaled back sooner than was previously expected. In terms of fiscal policy, some of that shift is happening automatically thanks to the economy’s performance: better tax revenue, less expenditure on welfare benefits, and less need for direct business support given that trading conditions have mostly been close to normal since we emerged from lockdown last June. The government’s inability to progress its capital spending projects with any timeliness is also limiting the fiscal stimulus relative to what the government might have hoped. Nevertheless, the fact that the government’s “spare cash” in the COVID Response and Recovery Fund has been whittled away from $14b to $5.1b since July last year, with money being spent on things like school lunches, cameras on fishing boats, and infrastructure for housing, suggests the government is still operating with a very stimulatory mentality.

The change in monetary policy will need to be much more marked. As recently as late 2020, discussion was still centred on whether the Reserve Bank’s next change to the official cash rate (OCR) would be upwards or downwards. Now, however, we forecast that the OCR will start rising by February next year, with five increases taking it to 1.5% by the end of 2023 (see Graph 6). This forecast remains under active review, with significant risk that the Reserve Bank increases the OCR before the end of 2021 given the rapid emergence of inflation concerns.

Graph 6

The Reserve Bank has also been steadily scaling back its government bond purchases, which began the year at $670m per week and are now sitting at $200m per week. The Bank insists that this tapering is an operational matter rather than a definite change in monetary policy, and that lower-than-expected levels of government debt are limiting its purchasing programme. This explanation is true, but the reduced rate of bond purchases is also highly convenient given the economy requires less stimulus going forward.

The Bank will be closely monitoring price pressures for signs that the current spike in inflation is not translating into a more sustained pick-up. The Bank’s May Monetary Policy Statement assumed a temporary lift in inflation, but concerns must be mounting that things could get out of control given the combination of supply and demand conditions we are now facing, particularly in the labour market. The strength of the latest Quarterly Survey of Business Opinion has raised the chances that the OCR could even be increased before the end of 2021.

The Bank has made it clear that the OCR will be the first tightening mechanism to be used. This approach contrasts with our expectations earlier this year that the Bank would operate a “last on, first off” method, which would have seen the Funding for Lending Programme and Large Scale Asset Purchases closed down first.

Momentum in house prices has remained strong despite the rule changes for investors announced by the government back in March. It is probably too early to expect much of a slowdown, but it seems that price trends are being dominated by a lack of properties available for sale.

We continue to expect the market to soften throughout the next 18 months, particularly as mortgage rates climb from their record lows. Four and five-year rates have been pushing upwards since March, and one and two-year rates will start to climb, as expected OCR increases get closer.

By late 2023, the lowest available mortgage rate is likely to be about 3.5%, a rise of around 120 basis points from the low recorded in the first half of this year. That increase would increase aggregate mortgage servicing costs by about $3.7b, which represents 1.8% of household disposable income. This lift in servicing costs is a key factor behind our forecast of just 1.3%pa average growth in household spending during 2022 and 2023.

Although these interest rate rises will be effective at reining in household spending growth and helping to slow the housing market, they will not be big enough to cause major stresses for households or lead to house price falls of any significant magnitude. Reserve Bank data shows that retail banks have reduced their test rates for checking mortgage servicing ability on new loans from 7.5% in late 2018 to 6.3% in March this year. This test rate is well above where mortgage rates are forecast to head within the next 2-5 years, and it has dropped by less than two-thirds of the fall that has been seen in actual mortgage rates. In other words, although consumers will find they have less money for discretionary spending over the next couple of years, their ability to service the mortgage should not be compromised.

Graph 7 shows that, between mid-2022 and mid-2026, we expect house prices to still track upwards, but at a considerably slower rate of 1.9%pa. Current very high residential consent numbers, combined with a substantial decline in underlying demand due to lower net migration, will see the undersupply of housing shrink quickly over the next couple of years. Rising mortgage rates and the changed incentives for investors due to the government’s rule changes are expected to lock in slower house price growth throughout the second half of the forecast period. However, the willingness of investors to sell is likely to be limited, due to the tax implications of the bright-line test on property sales. A lack of stock available for sale might keep more pressure on housing than originally expected.

Graph 7

Housing affordability will remain problematic for people who do not own their own home. Gradual increases in incomes by 2026 will not even be sufficient to undo even half of the increase in the ratio of house prices to incomes that has occurred since COVID-19 struck, let alone any of the prolonged and sustained rises that took place during the 2000s or 2010s. We expect no resolution of New Zealand’s housing crisis in the foreseeable future.

The frothiness of the economy’s current performance is unsustainable and implies that growth conditions will be more difficult in future. The burst of government and household spending associated with the fiscal and monetary stimulus of the last year cannot be sustained. Both the housing market and mounting inflationary pressures are demanding a return towards more normal or neutral conditions.

At the same time, the government has vowed not to fully resume previous immigration levels, which were such a key component of New Zealand’s growth story between 2014 and 2019. The government’s preferences for greater employment of New Zealanders and improved productivity outcomes are admirable. However, previous experience shows that it is difficult to push the unemployment rate much below 4% given that this pool of jobless are far from work-ready. New Zealand businesses also don’t have a great track record in terms of investing and achieving productivity improvements – possibly because of the prevalence of small and medium-sized enterprises. These smaller firms have restricted access to finance, a limited knowledge of available technologies, and struggle to achieve the scale to fully realise the benefits associated with major capital investments.

This combination of factors means that we expect New Zealand’s potential growth to be limited after 2021’s post-COVID bounce, with growth peaking at 5.2%pa at the end of this year. Graph 8 shows that we forecast GDP growth to average just 1.2%pa over the four years to June 2026, as high debt levels (both public and private) and a constrained labour supply see New Zealand’s economy stagnate.

Graph 8

Overall, the economy remains well positioned to recover further in 2021. Our previous concerns about vaccine rollouts and how we reopen to the world remain valid, but of rising concern is the likelihood of the economy overheating in the short term. Skills shortages, supply chain issues, and the resulting inflationary pressures all combine to raise flags about the sustainability of New Zealand’s post-COVID bounce.