Three-year slowdown looms for stretched domestic economy

Concerns about the domestic economic outlook are mounting, but we expect New Zealand to technically avoid a recession this year thanks to the impending revival of the tourism sector. However, apart from this area of positivity, the signs for the economy over the next 1-3 years are increasingly downbeat. Rising interest rates, a housing correction, and an inflationary squeeze on household budgets are reflected in record-low consumer confidence. Businesses continue to grapple with massive cost pressures, disrupted supply chains, and a lack of workers and capacity. Concerns have also escalated about the global outlook as China’s economy falters and central banks aggressively raise interest rates to try and tame inflation. We expect a temporary bounce in New Zealand’s GDP growth to 2.8%pa in 2023 as tourism recovers, but growth will slip to 1.6%pa during 2024 as demand consolidates to more sustainable levels than we have seen over the last couple of years.

Consumer confidence has been in a downward trend since mid-2021, and it plunged to a record low in both the ANZ Roy Morgan and Westpac McDermott Miller surveys in the June quarter. The drop-off in confidence is to be expected given the multitude of pressures that household budgets are coming under. However, the decline past the previous record low in 1991 (in the Westpac McDermott Miller survey) is startling given the high unemployment rate and extended recessionary conditions that characterised the early 1990s.

Households are being affected most critically by higher mortgage rates, with expectations for rates over the next couple of years continuing to be revised upwards as the Reserve Bank is forced to tighten further and faster than previously expected. The lift in mortgage rates since July last year has so far added about $30 to weekly repayments for every $100,000 of debt, although the full effects of the increases will not yet have been felt by most households. As Graph 1 shows, we haven’t seen the full effect of higher mortgage rates on households yet. Around 48% of mortgage debt is due to roll off fixed rates in the next year (26% within the next six months), so the interest rate rises will continue to suck more money out of household budgets throughout the rest of 2022 and 2023.

Graph 1

Higher food and fuel prices have also pushed up households’ essential living costs by about $15-25 per week each over the last year. In tandem with higher mortgage rates, these increases are reducing scope for discretionary spending and undermining growth in spending volumes.

The effects of falling house prices, rising interest rates, and tighter credit conditions on spending should also not be forgotten. Strength in the housing market, alongside lockdowns and increased working from home, boosted renovation activity and spending on homewares and appliances. For some people, it also presented an opportunity to buy a new car or boat – often in lieu of an international holiday. Aside from the backlog of construction work still awaiting completion, these spending categories appear susceptible as the economy has turned.

Although our forecasts of year-end growth in household spending have been revised up in the second half of 2022, this shift is primarily due to the exceptionally strong spending result in the March 2022 quarter. Some momentum in spending could persist throughout the middle part of this year, with reduced Omicron restrictions and fewer people stuck at home isolating. The government’s $350 Cost Of Living Payment between August and October is also likely to put a temporary floor under spending. But the full effects of higher mortgage rates are set to reduce spending growth to 2.1%pa by the end of 2023 and 1.8%pa by early 2025 (see Graph 2).

Graph 2

As in our previous sets of forecasts, the expected continued tightness of the labour market remains a major saving grace for households. Businesses across the economy are finding it virtually impossible to find and retain staff, and the lack of employment growth over the last six months (just 0.1%, according to the Household Labour Force Survey) at a time of strong demand reiterates the lack of available workers.

Wage inflation has so far stayed weaker than expected, but it is forecast to accelerate throughout the rest of 2022 and remain high during 2023. Workers remain in a strong bargaining position and will be increasingly desperate to be compensated for the higher living cost increases they are facing. The current environment of higher inflation also means that employers will be more likely to accede to these demands, with an expectation that they will be able to pass these costs onto customers, as has been the case with other costs.

We do not expect international migration flows to provide significant relief in terms of labour supply over the next 18 months. The exodus of young Kiwis to Australia and beyond will continue, reflecting high house prices and living costs in New Zealand, higher incomes overseas, and wanderlust caused by two years of being trapped by closed borders. Potential immigrants to New Zealand will also be put off by the disparity between incomes and house prices, along with the government’s desire for fewer immigrants, and limitations on processing capacity at Immigration NZ. The only areas likely to experience any noticeable improvement in the availability of workers might be the ones typically reliant on people on working holidays, such as parts of the hospitality, retail, and horticulture sectors. However, so far working holiday numbers have been more limited than anticipated, in part because of Immigration NZ’s extended delays to visa processing.

Although our labour market outlook is mostly unchanged, we have steepened our forecast rise in the unemployment rate to reach 4.0% in 2024 and a peak 4.4% in 2026. This slightly less favourable outlook reflects our view that the larger and sharper lift in interest rates currently being implemented by the Reserve Bank, and the commensurate reduction in spending and economic growth, will lead to a greater number of job losses and a faster return towards a more sustainable level of employment.

Graph 3

Graph 4 shows that expectations of global economic growth have softened throughout 2022. In part, the deteriorating outlook reflects many of the same issues our own Reserve Bank is grappling with, as international central banks look to dampen down inflationary pressures and reduce the gap between excess demand and constrained supply.

Graph 4

The war in Ukraine has created its own challenges for European economies, with the conflict causing increased uncertainty in the region. It goes without saying that the war’s effect on oil and natural gas prices has also dramatically affected the costs of many business operations and added further disruption to economic activity.

China has also shown concerning signs of softness. In part, Chinese activity has been hit by its government’s zero-COVID policy, which resulted in an extended lockdown in Shanghai and several other cities earlier this year. Softening demand in other countries has also undermined demand for Chinese exports. But beyond these factors, there appears to be an underlying trend of weakness in Chinese domestic activity as well. This vulnerability in the Chinese economy is arguably at its most pronounced since the Global Financial Crisis – an event that resulted in substantial government stimulus to ensure that China fared better than most other economies and became the major engine of the global economy. A similar approach seems unlikely this time around, reflecting that the government is trying to transition the economy towards a more sustainable model of growth. No longer is GDP growth something to be pursued for its own sake. Given that China takes 31% of our exports and is New Zealand’s largest trading partner, this change leaves our exporters in quite a vulnerable position.

Against this backdrop, ANZ’s world commodity price index for New Zealand exports has declined 6.5% since March. Export prices remain relatively high in historical terms, but this softening points to the increasing risks posed by the softer global economic outlook.

These risks have also affected the exchange rate, which has been driven down to its lowest level against the US dollar since 2009 (apart from the brief drop that occurred when COVID-19 first hit in 2020). Aside from concerns about New Zealand’s export position, expectations of interest rate rises internationally have also overtaken our Reserve Bank’s programme of tightening and seen investors chasing higher interest rates elsewhere. Furthermore, risk aversion among international investors has also led to the US dollar being driven higher and the New Zealand dollar falling out of favour.

The Reserve Bank’s most recent Monetary Policy Statement showed the official cash rate (OCR) pushing towards 3.5% by the end of this year and up to a high point of about 4% during 2023 (see Graph 5). Most forecasters had previously thought the Bank’s predicted speed and magnitude of interest rate rises was underdone given the extent of inflation pressures, but there is now a general belief that the projected increases are sufficient to bring things back under control. In fact, most forecasters (including ourselves) expect the OCR to peak at around 3.5%.

Graph 5

Although most forecasters (including us) expect the OCR to peak at around 3.5%, several areas of significant uncertainty remain around the appropriate path for monetary policy settings.

• Indicators of economic activity continue to be disrupted by COVID-19 and the policy responses to the pandemic. Isolation requirements have stretched the labour force but also weighed on demand, and sectors such as hospitality and tourism have been operating well below “normal” due to border closures and uncertainty around people’s forward planning.
• Supply chain disruptions, high energy prices, and elevated shipping and freight costs remain problematic. International shipping costs have started to moderate recently, but they are still 4-5 times their pre-pandemic levels. It is unclear how soon further improvements in these supply issues will occur.
• The Reserve Bank’s failure to respond quickly enough to accelerating inflation last year means that it is now being forced to raise interest rates faster and further that might have otherwise been needed. With inflation up at 6.9%pa, an OCR of 3.5-4.0% is still deeply negative in real terms and might not be enough to get price pressures under control.

We are staring down the barrel of a slowdown in the domestic economy in coming quarters, particularly given high household debt levels and a heightened sensitivity to interest rate rises. Given this outlook, we would normally be starting to think about the next easing cycle for monetary policy. However, the wide imbalance between demand and supply means the focus must remain firmly on bringing inflation back under control and bringing aggregate demand back in line with the economy’s ability to supply.

For the first time in over a year, we have not revised up our forecast inflation peak (see Graph 6). But we expect it to take longer for inflation to ease back within the Reserve Bank’s 1-3%pa target band. International supply issues and cost pressures will keep inflation higher for longer, and domestic wage pressures and embedded expectations of stronger inflation will also prevent the Bank hitting its target for longer. We forecast that inflation will still be over 6%pa at the end of 2022, above 4%pa at the end of next year, and over 3%pa in December 2024.

Graph 6

The pressures on the domestic economy and concerns about global demand conditions mean that New Zealand’s economic growth will falter over the next 18 months. The saving grace is that exports, particularly services exports, have significant capacity to lift from current levels. Increasing visitor arrivals and recovering tourism activity will be a key contributor to economic growth during 2023. Even with question marks hanging over some of our goods exports, we are forecasting 8.9% growth in total export volumes next year, feeding through into GDP growth of 2.8%pa.

Graph 7

However, that growth will feel very patchy, on both an industry and regional basis. The combination of flagging domestic demand, persistent supply limitations and capacity constraints, but a concentrated recovery in tourism-related sectors, will play out unevenly across the country.

Ultimately, we remain of the view that economic growth in 2024 and 2025 will be significantly harder to achieve. The massive borrowing of the last two years to cushion the effects of COVID-19 has effectively brought forward future activity and leaves less scope for the economy to grow over the medium-term. It will only be once a greater level of balance between demand and supply has been achieved, reflected in reduced inflationary pressures, a modest lift in the unemployment rate, a correction in the housing market, and slower growth in government spending, that GDP growth will push back up towards 2.4%pa in 2025/26.