Welcome to 2022, and Omicron

When we published our previous set of forecasts in October 2021, New Zealand was still battling Delta, and Omicron had yet to emerge. Our latest forecasts include the expected immediate effects of the current Omicron outbreak and the move to Red “traffic light” settings across the country. Aside from these near-term changes to activity, many of the same issues remain key for the economic outlook over the next couple of years: cost and price pressures, the availability of labour, the resilience of household spending, and the housing affordability crisis. The stresses and capacity limitations across the economy mean that growth is becoming more difficult and expensive to achieve, and the COVID-19 rollercoaster ride is far from over yet.

Even prior to Omicron being confirmed in the community and the government’s move to the Red “traffic light” settings in the second half of January, we had incorporated the effects of an Omicron outbreak into our economic forecasts. Given the spread of the virus overseas and the increased number of cases being caught at the border, it seemed only a matter of time before Omicron found its way into New Zealand and started disrupting economic activity. On this basis, we knocked about two percentage points off our GDP forecasts for the March and June quarters.

The effects of Omicron on activity are likely to be slightly different and more nuanced than the disruptions caused by the lockdowns during 2020 and 2021. We have provided more detail on the likely effects of the Omicron outbreak in Exploring Omicron’s potential economic impact on New Zealand , with a summary of the main features and outcomes below.

• Experience shows that the economy has become more adept at working from home as the pandemic has progressed, with the Delta lockdown having a smaller negative effect on GDP than the initial lockdown in 2020. In general, the Red traffic light setting does not prevent businesses from operating, so firms in industries such as construction and manufacturing will be able to keep working, unlike at Alert Level 4. Treasury estimates that the Red traffic light setting will reduce GDP by 2-3% from “normal” levels.
• The effects of restrictions will be heavily concentrated in the hospitality and events sectors, with the capacity of venues generally capped at 100. Spending data in late 2020, when the Red setting was in Auckland and some other parts of the country, suggests that spending at restaurants and other hospitality venues was 20-30% below normal. Just as the tourism sector bore the initial brunt of COVID-19, with the borders being closed, we are now seeing more closures in the hospitality sector as prolonged restrictions render businesses unviable.
• The hit to revenue in the hospitality sector will be exacerbated by an increased hesitancy from people to go out to locations such as restaurants where there is a higher risk of catching the virus. Overseas data shows that the number of diners in restaurants has dropped about 25% as Omicron has spread.
• The expected surge in case numbers, as we have seen in Australia, is also likely to result in an absenteeism rate from work of over 10%. Large numbers of people will be forced to isolate, either because they have caught the virus, or they are a close contact of a COVID-19 case. Although many businesses have more flexible working arrangements than they did prior to 2020, the nature of some jobs means that people will not be able to work from home.
• Supply chains, which have already been significantly disrupted internationally over the last couple of years by COVID-19, will come under further pressure from absenteeism. The disruption to domestic supply chains will occur in the production, distribution, and retailing of goods as staff are unable to come to work.

The effects of the Omicron outbreak are shown in our GDP forecasts in Graph 1. Economic activity will be constrained in the near-term, with year-end growth at the end of 2022 sitting at 1.4%, rather than the 3.6%pa we were previously forecasting. With fingers crossed, a rebound towards uninterrupted economic activity would see GDP growth of 3.7%pa for 2023.

Graph 1

The likely supply chain disruptions noted above represent the latest in a long run of factors that have contributed to the rapid acceleration in inflation over the last year. Our central view is that inflation has peaked at 5.9%pa in the December 2021 quarter, but Graph 2 shows that we expect underlying pricing pressures to remain elevated during 2022, with inflation still outside the Reserve Bank’s target band, at 3.6%pa, at the end of this year.

Graph 2

The risks to this inflation forecast are still on the upside. The flow-on effects of very high international shipping costs and significant increases in petrol prices during 2021 have yet to be fully factored into domestic prices for goods faced by businesses and consumers.

Against this backdrop, the Reserve Bank will be compelled to tighten monetary settings with more gusto than it did in the latter part of 2021. Other central banks have moved away from their previously held viewpoints that much of the inflation was temporary or outside their control, to better recognise the inflationary effects of massively stimulatory monetary and fiscal policy since the pandemic began. We expect the official cash rate to reach 2% before the end of this year, climbing further during 2023 to a peak of 2.75% (see Graph 3).

Graph 3

Apart from the inflationary factors noted above, the very tight labour market will be an increasing source of cost and pricing pressures throughout the next 12-18 months. Wage inflation has failed to keep up with increases in consumer prices over the last year, let alone the rising cost of living associated with climbing mortgage rates. The unemployment rate of under 3.5% lines up with a raft of other indicators showing that employers are struggling to find and retain staff, implying that workers are in a stronger bargaining position.

Employers might find some relief from the second half of 2022 if the government’s plans to relax border restrictions and MIQ requirements come to fruition. The emergence of Omicron internationally means that the timelines have slipped from what was originally announced in November. However, it is likely that the spread of Omicron within New Zealand will enable the government to proceed with its self-isolation model, with less risk associated with self-isolation as Omicron is already in the community. We have slightly delayed our forecast pick-up in net migration, but we still expect the net inflow to recover to almost 45,000pa by the end of 2023.

As we have indicated in previous forecasts, the uncertainties around these international migration flows are massive. The unknowns include the exact timing and nature of border changes, the pent-up demand from Kiwis to take off on their OEs, the potential rush of Kiwis who have been kept offshore by the MIQ bottleneck, the processing capacity of Immigration NZ to approve visas for foreigners looking to come and work here, and the drawcard that Australia offers to Kiwis once borders reopen. Regarding the final point, higher incomes and lower housing costs could encourage more people to head across the Tasman. However, these effects might be mitigated by the fact that New Zealand’s labour market remains tighter than Australia’s, with unemployment rates of 3.4% and 4.2% respectively.

Over the two years of the pandemic to date, we have been pleasantly surprised by the continued strength of consumer spending and the New Zealand economy’s ability to adapt and bounce back from lockdowns. Heading into 2022, there are several factors that make us nervous about prospects for household spending, but we are also wary of being overly downbeat about the outlook given the economy’s recent resilience.

Consumer confidence at the end of 2021 weakened across all three surveys we monitor, with the recent 1 News Kantar Public (formerly Colmar Brunton) poll recording its worst result in almost 14 years. During 2020, households’ concerns about their financial situation were mitigated by rapidly declining interest rates and the relatively quick shift from lockdown back towards something like normal. Now, consumers are grappling with a faster-than-expected lift in mortgage rates, significant price increases for other household essentials such as fuel and food, and concerns about the continuing nature of the pandemic and living with COVID-19 in the community. These factors will substantially squeeze households’ discretionary spending throughout the next two years, and they provide a significant downside risk to our assumed recovery in spending during 2022 and 2023.

As previously outlined, evidence from overseas also suggests that the spread of Omicron is also constraining consumer behaviour. Surging case numbers have led to a high number of people isolating due to infection or being close contacts, and concerns about potentially catching the virus are also discouraging people from visiting perceived higher-risk venues such as restaurants. The fact that New Zealand has avoided widespread community outbreaks of COVID-19 to date means that Kiwis might be even more risk averse than people overseas, and less willing to go out as the virus starts to become endemic across the country.

In summary, we expect household spending to have fully recovered by mid-2023 (see Graph 4). But we caution that spending could be patchier and less resilient over the next 18 months than we have experienced so far during the pandemic. We also note that medium-term growth, from 2024 onwards, is likely to be modest as households readjust to higher mortgage rates.

Graph 4

Higher interest rates will also be a contributing factor to the housing market finally slowing this year. We are forecasting the lowest available mortgage rate to have climbed from 3.6% to 4.3% by the end of this year, lifting further to 4.8% by the end of 2023. Impending rises are not as large as our forecast increase in the official cash rate because longer-term rates have effectively already priced in some of the Reserve Bank’s expected tightening. Nevertheless, the lift would see mortgage rates in two years’ time at their highest level since 2016.

Although this outlook has raised concerns about mortgage-holders’ ability to meet their increasing repayments, we believe the likelihood of defaults remains low. Longer-term homeowners will have smaller mortgages, and their borrowing will have been premised on the higher mortgage rates that prevailed pre-pandemic. And for recent entrants into the housing market, banks have been applying test interest rates of over 6% when assessing the ability of borrowers to meet their mortgage obligations. The very tight labour market will maintain good job and income security and prevent a discernible rise in mortgagee sales.

Amid the raft of changes made in 2021 to try and quell house price inflation, it is ironic that the side-effects of the government’s changes to the Credit Contracts and Consumer Finance Act are the most significant factor slowing the housing market in the near term. These changes have led to a major credit crunch, reducing the number of potential buyers in the market and cutting the amount of money that people are able to borrow. People’s borrowing power is also being crimped by the rebound in mortgage rates since mid-2021, which has increased debt-servicing costs and made it less feasible for people to pay such high prices for property.

The government has indicated it will review its changes to the Credit Contracts and Consumer Finance Act, but it will also be keen to avoid a resurgence in house price inflation given the housing affordability crisis. We expect any regulatory or legislative changes to take at least six months to implement, by which point the loss of momentum in the housing market will have reduced demand driven by the fear of missing out. The likely introduction by the Reserve Bank of debt-to-income ratio restrictions and floors to test mortgage rates will also act as additional, and more well-targeted, limitations on borrowing going forward.

We expect house price growth to have eased to 4.5%pa by the end of this year (see Graph 5). We are not forecasting house price falls at this stage, with an expected pick-up in population growth likely to counteract the effects of rising interest rates and the increased supply of new dwellings becoming available. Regulatory changes, including the new Medium Density Residential Standards and the National Policy Statement on Urban Development, point towards a risk of a small dip in house prices within the forecast period. However, any declines are likely to be modest in the context of the estimated 44% surge in house prices over the last 18 months.

Graph 5

Aside from the raft of domestic issues to grapple with, we also note three important concerns arising from overseas that could undermine New Zealand’s growth prospects.

China’s economic indicators have been sluggish over recent months and hint at difficult growth conditions in 2022. Factors include restrictions and lockdowns associated with the government’s ongoing pursuit of a zero-COVID policy, more focus on environmental outcomes rather than a simple pursuit of economic growth, ongoing concerns about Evergrande and the health of the Chinese construction industry, as well as disruptions to international demand and supply chains caused by COVID-19. With the country now taking a record 33% of our exports, weaker growth in China will inevitably affect our export revenue and growth outlook. The only saving grace is that, amid a Chinese economic slowdown, demand for our food exports seems set to hold up relatively well.

Tensions on the Russia-Ukraine border have been steadily increasing. The most immediate effects on New Zealand of conflict breaking out would come through in financial market indicators, with supply concerns likely to push oil prices up further, while risk aversion would drive down longer-term interest rates. The geopolitical instability and channelling of resources towards military activity could also dampen economic growth in Europe.

It is far from guaranteed that Omicron will be the final wave of COVID-19 disrupting the global economy . Although the lockdowns and severe disruptions of 2020 seem unlikely to be repeated at this stage, the return towards “normal” after the pandemic will probably not be smooth. Businesses will need to stay nimble to adjust to future twists in operating conditions. As the last two years have shown, each new stage of the pandemic has its own challenges and differences from previous outbreaks.