Time to pay the piper… more

The last two years have seen the New Zealand economy shrug off almost every expected effect of the global pandemic. Finance Minister Grant Robertson has whistled a merry tune as the $69b COVID-19 Response and Recovery Fund has supported employment and household spending. Massive monetary stimulus courtesy of his sidekick, Reserve Bank Governor Adrian Orr, has also fuelled the spending frenzy. But the economy is stretched to breaking point, and households are being confronted with the prospect of scaling back their demand as everything becomes more expensive. As was the case in Hamelin, those costs could extend to a loss of people, with New Zealand’s high cost of living potentially causing a brain drain over the next couple of years.

The continuing acceleration in inflation is the most obvious symptom of the stresses the economy is under. All forecasters have consistently underestimated the length and strength of the pick-up in inflation over the last year – as recently as May 2021, the Reserve Bank was predicting an inflation peak of 2.6%pa! The Bank’s latest forecast, from February, predicts a peak of 6.6%pa, while our updated projections see inflation getting up to 7.6%pa. In reality, inflation could well go higher.

The Bank is guilty of losing focus on its target of keeping inflation between 1% and 3%pa over the medium term. At first glance, this loss of focus might have arisen because of the increasingly multifaceted objectives the Reserve Bank has to grapple with, including “support[ing] maximum sustainable employment” and considering the government’s aim for “more sustainable house prices”. In reality, all three of these indicators have been screaming out for higher interest rates since mid-2021, yet the Bank had managed increases totalling just 75 basis points by the end of March.

Instead, behind the Reserve Bank’s monetary policy failure is a combination of poor judgment and poor decision-making. The poor judgment relates to the Bank’s initial assessment that the acceleration in inflation was largely due to transitory or one-off factors. We won’t hold that assessment against the Bank given it was difficult to distinguish the temporary pressures from the more sustained ones as inflation picked up last year.

However, the Bank’s decision-making has appeared to be deeply flawed, with the Bank choosing to unduly emphasise the downside risks to the economy, despite it being increasingly obvious that both monetary and fiscal stimulus were stoking the demand fires out of control. The fact that both non-tradable and tradable inflation have hit 30-year highs demonstrates that the inflationary pressures have both international and domestic origins. Although the Bank can do little about international shipping and supply chain disruptions, soaring oil prices, or the war in Ukraine, it has a responsibility to dampen the domestic economy to ensure that local demand pressures don’t exacerbate the inflationary fires. The Bank’s lack of appropriate monetary policy focus is epitomised by its seeming obsession with mitigating the effects of climate change – a subject that falls outside its remit, apart from a brief mention of the “Government’s priority … to move towards a low carbon economy”.

The irony is that the Bank’s hesitancy to take firmer monetary policy action during the second half of 2021, partly for fear of causing a sharp economic slowdown, means that more interest rate rises will be needed over the next year as it plays catch-up. Graph 1 shows that we now expect the official cash rate (OCR) to get to at least 2.5% by the end of 2022, and we are forecasting a peak of 3.25% in 2023. There will be no mortgage rates below 5.5% by the first half of next year – an outcome that will be uncomfortable for borrowers and lenders, given that banks were using test mortgage rates of just 6.1% for their lending decisions in late 2021. Household budgets will be squeezed considerably, particularly for people who have borrowed heavily over the last couple of years with the expectation that interest rates would persist near their record lows for longer.

Graph 1

By historical standards, our forecast peak of 3.25% for the OCR is relatively low, and it indicates that the Reserve Bank will look to maintain a “softly, softly” approach as much as possible, as it tries to avoid sending the economy into a recession and the housing market into a nosedive. At the same time, feedback from the business community indicates that a cost-plus mentality has quickly become factored into pricing behaviour, and that inflation could become embedded at a higher level. Discussion of a wage-price spiral is particularly pertinent given the tightness of the labour market, the likelihood of accelerating wage inflation, and the need for businesses to pass on those higher costs.

Graph 2

On this basis, we forecast that inflation will still be high, at 5.7%pa, at the end of 2022, remain outside the Reserve Bank’s 1-3%pa target band at the end of 2023, and hover about 2.5%pa during 2025 (see Graph 2). The Bank’s lackadaisical response to the current inflation spike has undermined the Bank’s inflation-fighting credibility and will continue to erode people’s purchasing power for some time to come.

Although we have plenty of brickbats for the Reserve Bank’s response over the last nine months to the surge in inflation, the government is arguably now even more culpable for the stresses the economy is under. The volume of government consumption spending grew 10% during 2021, which we estimate is the fastest growth since about 1977/78. Government investment spending has also rebounded from a weak result in 2020, increasing by 6.9% over the last year. The ongoing acceleration in spending growth is demonstrated in Graph 3.

Graph 3

The burgeoning size of government is also reflected in employment data. Total job numbers across the public administration and safety, education and training, and health care and social assistance industries have increased by 8.4% over the last year, compared to 2.6% growth across all other industries. [1] We recognise that some jobs in these industries, such as in private schools and hospitals, will not be public sector roles, and that significant growth in the health workforce is to be expected in a pandemic. Nevertheless, the reality is that the government has been hoovering up workers at a rate that is placing significant stress on the private sector, given the lack of spare labour in the economy and the restrictions on the labour supply implied by the border closures.

Put simply, these rates of growth cannot continue without exacerbating economic pressures even further. Our forecasts of government consumption over the last year have consistently expected spending growth to peak and fall away in the short-term, but it has continued to climb higher. These results reflect the inertia of fiscal policy and the impracticability of quick adjustments in government spending outcomes. So even though Grant Robertson has made noises since the start of 2022 about less fiscal support being available for the economy going forward, there are still upside risks to our government spending forecasts this year. There might be more potential for the residual effects of previous policy decisions to flow through into demand and GDP results than we have allowed for. Just as concerningly, there was still $4.3b left in the Covid slush fund at the end of last year, which could yet be spent.

Arguably even more concerning than government consumption are government investment outcomes. There has been a lot of government talk about major infrastructure spending. Key investment programmes include the “shovel-ready” projects announced in the second half of 2020, the NZ Upgrade Programme ramping up to peak activity in 2024, requirements for massive investment in the three waters networks, and the need for infrastructure upgrades and expansions to facilitate the government’s ambitious housing reforms. Local councils across much of the country also face considerable pressure to increase their investment in network infrastructure and make up for years of underinvestment.

The risk is that all these pressures come to bear in a highly stretched economy that simply does not have the resources to increase output to meet demand. The government runs the risk of pumping a lot more money into infrastructure but achieving little or no growth in terms of output volumes. Instead, the extra funding could quickly be gobbled up by price rises given the current inflationary environment. After a rally in activity over the next 12 months, we now expect infrastructure work to decline in 2023/24 as higher prices and capacity constraints lead to cost overruns in the near term and force a reassessment of the output volumes that can realistically be expected in 12-24 months’ time.

The spread of Omicron throughout New Zealand has led to the government bringing forward its timing for the border reopening. At first glance, this change would appear to be good news for businesses struggling to find workers with the unemployment rate down at 3.2%. But despite access to workers from overseas set to improve, we are increasingly worried that any lift in foreign arrival numbers could be overshadowed by a surge in the number of Kiwis heading offshore.

Our concern is centred on two key groups. Firstly, we estimate that about 40,000 mostly young people have not departed on their OE over the last two years due to COVID-19, reduced air connections, and uncertainty about their ability to return to New Zealand given the MIQ bottleneck. The recent dismantling of MIQ has removed the last major impediment, and we expect to see more of an outflow appear in coming months. Even if half of the 40,000 young people who have delayed their OEs now choose not to travel, the “catch-up” of the other 20,000 over the next two years, alongside a resumption of the usual outflow of 20,000pa on their OE, would result in an increase in Kiwi departure numbers of about 30,000pa.

The second key group is the potential outflow of people to Australia. At 4.0%, Australia’s unemployment rate is still 0.8 percentage points above New Zealand’s rate. This gap is in line with the average differential over the five years prior to COVID-19, when the net outflow to Australia was relatively small. In other words, the relative labour market performance still looks to be in New Zealand’s favour. However, the current squeeze on household budgets from the rising cost of living will be encouraging more Kiwis to look at opportunities across the Tasman, where higher incomes provide a greater buffer against increasing living costs.

Housing costs, which have typically worked in New Zealand’s favour, are arguably the final straw. Since June 2017, Australian house prices have risen by an average of 26%, whereas New Zealand’s house price increase has been 63%. Permanently relocating to Australia must look like an increasingly attractive option to enable people to get ahead, particularly for people who are not currently homeowners.

At the same time as New Zealand faces a significantly increased migration outflow, there is no guarantee of a quick rebound in the number of foreigners moving here. Despite softening its stance from the immigration “reset” announced almost a year ago, the government remains reluctant to allow a resumption of the large influx of foreign workers into the country. The government’s focus remains on upskilling and employing New Zealanders, coupled with talk of improving the economy’s productivity. These are laudable goals, but ones that are mostly filled with rhetoric and are disconnected from the reality of a 3.2% unemployment rate, with a longer run-up needed to achieve productivity gains. Given the government’s aspirations, we expect resident and work visa approvals will be relatively constrained over the next couple of years.

Two other factors have led us to adopt a cautious forecast to the rebound in immigration. Firstly, ongoing restrictions and caution from the government in its COVID-19 response are likely to put off some potential migrants, particularly as most of the rest of the world has moved more fully into a “living with Omicron” phase. In this regard, New Zealand will be less attractive for migrant workers than the US or Australia. Secondly, we have ongoing concerns about Immigration NZ’s processing capacity, which could be used as a de facto way of limiting migrant numbers, much as it was in the two years prior to COVID-19, when processing times and the backlog of applications blew out.

This combination of factors, coming on the back of downward revisions to recent migration numbers by Stats NZ, means that we are now forecasting a net outflow of over 12,000 people in the year to June 2022. Although we expect net migration to be back in positive territory next year, a slower pick-up in arrival numbers and the increased number of departures mean our net figure for 2023 is about 37,000 people lower than previously predicted (see Graph 4). Even with that downward revision, and the net outflow could be larger and persist for longer than we have allowed for.

Graph 4

The gap between our latest and prior migration forecasts shrinks during 2024 and 2025 as the catch-up in OEs runs out of steam, although persistently tighter immigration settings from the government see the net inflow peaking at about 32,000pa rather than 40,000pa.

Discussion in the previous sections around interest rates and net migration make it clear how quickly, and markedly, the ground has shifted under the housing market. A lot of the chatter around the housing market’s slowdown over the last few months has been centred on the changes to the Credit Contracts and Consumer Finance Act (CCCFA), which came into force into December last year. Although these changes reduced the availability of credit and helped reduce the market’s momentum, the reality is that other forces were already at play before the CCCFA gate-crashed the party.

The reintroduction of loan-to-value restrictions and their tightening in subsequent months had squeezed buyers out of the market and funnelled demand from both investors and owner-occupiers towards new builds, which are exempt from the restrictions. The rapid reversal in mortgage rates had not been anticipated the previous year and, even now, interest rate expectations continue to be revised upwards. These rate increases have exposed the unaffordability of house prices, and potential buyers are now baulking at such high property values and the associated debt-servicing costs.

The effects of the major drop-off in population growth probably have yet to be fully realised by the market, given the undersupply of housing that had developed throughout much of the 2010s. However, as the current rush of almost 50,000 consents per annum is completed during the next couple of years, the undersupply will no longer be a defining feature of the market, and weak population growth in tandem with the high residential build rate will become much more important.

Graph 5

Against this backdrop, the question is not whether house prices will fall but, instead, by how much. Graph 5 shows that we are currently predicting a nationwide decline of 5.3% in average prices during 2022, with a tail of smaller falls persisting through into 2023 and 2024. Even then, our predicted falls appear to be conservative, and there are two reasons for this outlook.

• The labour market will remain extraordinarily tight throughout the next two years (see Wage pressures and lack of workers constrain growth), meaning that forced sales will be virtually non-existent.
• Relatively high consumer price and wage inflation means that the decline in real property values will be quite a bit larger than the nominal falls.

Given how sharply the housing market drivers have turned, and how overvalued housing appears to be, we recognise the downside risks to our house price forecasts. Price falls of up to 10% this year look possible, and Auckland’s very high property values make the city more susceptible to a correction than most regions.

In the context of how far prices have risen, even a 10% reversal isn’t really that large. After allowing for inflation, a 10% decline would still leave real house prices higher than they were at the end of 2020.

Our net migration outlook means that population growth is forecast to bottom out at a 33-year low of 0.3%pa this year, before slowly recovering to 0.6%pa at the end of 2023 and 1%pa by the second half of 2025. With the unemployment rate already at 3.2%, the implied stresses on the labour market will be intense. We expect the unemployment rate to remain below 3.5% through until the end of 2023, and the lack of workers could even see the unemployment rate slip below 3% over the next 18 months. The participation rate will be forced higher as desperate employers draw more people into the workforce, and the unemployment rate is set to stay below 4% throughout the forecast period.

Wage pressures, which have been surprisingly subdued so far, will accelerate rapidly during 2022, with wage inflation holding above 5%pa throughout 2023 (see Graph 6). Workers will request larger pay rises to compensate them for rapid increases in the cost of living, and employers will have little choice but to meet those demands or lose staff to someone more willing to pay up.

Graph 6

Recent data is already pointing to the emergence of a slowdown in employment growth. The dearth of additional available workers has seen filled job numbers decline in two of the last three months. Year-end growth in employment, as measured by the Household Labour Force Survey, is set to slow from 3.4%pa in June 2022 to just 1.1%pa by mid-2023, and we see little scope for it to get much above 1%pa throughout the following three years.

For an economy that, prior to the pandemic, had based much of its growth around an increasing population and worker numbers, the next few years could prove tricky. To meet demand and achieve growth, firms will need to turn to increased capital investment. This option should become more attractive and cost-effective as wage growth accelerated during 2022 and 2023.

Nevertheless, the constraints that will be felt across the economy are still readily apparent in our forecasts. GDP growth will be more subdued during 2023 than we had previously forecast, and it is expected to slip below 2%pa during 2024 (see Graph 7).

Graph 7

None of this is to say that the New Zealand economy is set for a death spiral. But the combination of factors outlined in our latest forecasts show that after two years of cheap and easy money, and a buttress of supports, growth will be much harder and more costly to achieve during 2022 and beyond.

 

 

[1] This data, from the Quarterly Employment Survey, does not include the agricultural sector.