Taming inflation will stunt growth for two years

Inflation might have peaked at 7.3%pa in the June quarter, but cost and pricing pressures are still posing some big questions for the New Zealand economy. How quickly will inflation retreat to more acceptable levels? How much higher does the Reserve Bank need to push interest rates before it can be confident it has properly tamed inflation? And what scope is there for the economy to grow in the face of less favourable conditions, both domestically and internationally?

Firstly, the good news: the decline in petrol prices during the September quarter will knock about 0.2 percentage points off inflation, a sharp contrast to the 0.3 percentage-point contribution that came from fuel prices a year ago. This swing of 0.5 percentage points makes it difficult for annual headline inflation not to ease from the June quarter result.

Lower diesel prices might also be taking a bit of heat out of domestic inflationary pressures, with the average diesel price having eased from $2.98/L in early July to about $2.50/L more recently. But the reality is that diesel prices are still up around 60% from a year ago, and it is unlikely that this surge in fuel costs is fully reflected in domestic transport rates or the prices of all other goods and services. We expect further inflationary effects of this year’s fuel price spike to flow through the economy for some months yet.

International shipping costs have also been trending downwards since September 2021. Drewry’s world container index has dropped 57% from last year’s peak, but container prices are still 2.6 times higher than at the end of 2019. More locally, New Zealand importers have not enjoyed as much of a decline in freight costs. International shipping companies remain reluctant to service the China-Australasia route, which is less profitable than travelling between China and the west coast of the US.

Apart from these flickering beacons of hope, almost all other indicators of inflation remain strong. Food price inflation is at a 13-year high, as is producer input price inflation, and both inflation measures are still accelerating. Inflation expectations and survey measures of cost and pricing expectations are still highly elevated. Wage inflation has surged to a post-1980s high of 6.4%pa.

The New Zealand dollar has also become increasingly unhelpful for the Reserve Bank in its battle against inflation. At the time of writing, the exchange rate was down more than 20% from its level of US72c reached in October last year. Although much of the exchange rate story is one of US dollar strength, rather than NZ dollar weakness, the depreciation will still flow through into higher prices for tradable components of the consumers price index over the next 6-12 months. In other words, the lower NZ dollar will keep inflation higher than would otherwise have been the case during 2023.

In setting monetary policy, the Reserve Bank needs to be as forward-looking as possible, on the basis that interest rate changes take 9-18 months to have a real effect on the economy. On this basis, the Reserve Bank needs to predict how inflation and the economy will look by the end of 2023. The Bank’s most recent forecasts show consumer price inflation of 3.8%pa in December 2023 – heading in the right direction, and a sign of success when taken alongside an unemployment rate of 4.5% and rising, as well as economic growth languishing below 1%pa.

But the Bank’s stuttering start to interest rate rises in late 2021 and early 2022 means that it has lost some of its inflation-fighting credibility The Bank needs to act decisively to rebuild its credibility, so the risks associated with being too soft, allowing inflation to surprise on the upside or persist for longer, are arguably greater than the risks of overdoing the tightening and causing a greater slowdown in the New Zealand economy than is necessary.

By February 2023, following its three-month break over summer, the Reserve Bank will have inflation and labour market data for the September and December 2022 quarters. Given current trends in pricing pressures and wage inflation, we don’t expect the Reserve Bank will have sufficient information to be confident it has got on top of inflation properly. As a result, we anticipate that two further interest rate rises will be necessary in the first few months of 2023, taking the official cash rate to 4.5% (see Graph 1).

Graph 1

This forecast represents a full percentage point increase in our prediction for the peak in the official cash rate compared with our previous forecasts published in July.

Although our outlook for interest rates is higher than in July, our forecasts for inflation are largely unchanged. By implication, this combination reflects our view that, without the additional tightening built into our forecasts, inflation would take even longer to get back within the Reserve Bank’s 1-3%pa target band than our current prediction of March 2025.

The biggest repercussions of these additional interest rate hikes are likely to be felt in the housing market. We are now forecasting that one-year fixed mortgage rates could push close to 6.5% in mid-2023, leading to significant stress for borrowers with large debts that bought property in 2020/21. At that point in time, banks were using test rates of about 6.2% in their calculations to ensure borrowers could still service their debt when interest rates rose. There is now a clear risk of a significant increase in mortgagee sales occurring.

Even higher mortgage rates will also continue to shrink the amount of debt that potential borrowers can service when buying a property. In tandem with the expected rise in forced sales, we expect this trend to maintain additional downward pressure on house prices throughout the rest of 2022 and 2023.

The squeeze from higher interest rates will also flow through household budgets into weaker growth in household spending. Over the three years to December 2024, we are now forecasting that household spending will grow by an average of just 1.5%pa, compared with expectations of 2.6%pa growth in our July forecasts (see Graph 2).

Graph 2

Business investment and hiring decisions will also be affected by deteriorating demand conditions. We have revised down our forecasts of growth in business investment, but arguably the most critical shift is the more pronounced deterioration in the labour market. We now expect the unemployment rate to climb to 4.8% by mid-2025 and 5.0% during 2026, compared to our previous forecast of a peak of 4.4%. Implicitly these forecasts represent an increase in the number of unemployed by almost 60,000 people between 2022 and 2026, and they indicate the need for the economy to experience a period of spare capacity to ensure that cost pressures and pricing behaviour are brought back under control.

It’s important to put these figures in perspective – pre-pandemic, a 4.0% unemployment rate was very low for New Zealand, and so it would be natural to get back around that level again. To achieve that shift, people who might otherwise have been looking for jobs when the market was red hot could eventually look to retrain or might not engage in the labour market as fully.

Even with the unemployment rate climbing from 2023 through to 2026, the tight labour market and lack of available workers will remain a constraint on the economy over the next 6-12 months. Industries where demand is picking up, such as hospitality, tourism, and events, will struggle to rebuild their workforces and capacity, because previous employees have moved on to roles in other industries in the wake of the pandemic.

The net migration situation also remains a major concern for employers, particularly the loss of young people heading overseas. There has only been one period since 2001 when the net outflow of 20-29-year-olds was larger than it is currently – during 2011 and 2012 following the Christchurch earthquakes. Getting down to 3.4% in July, Australia’s unemployment rate has not been lower since at least the 1970s, and the job and income opportunities combined with more affordable housing and living costs in Australia are proving to be a significant drawcard for Kiwis. The loss of young people to Australia and beyond is leaving a significant hole in the supply of workers.

At the same time, high housing and living costs are also acting as a deterrent for foreigners considering migrating to New Zealand. These negative factors are being compounded by an international perception that New Zealand has been slow to “reopen” after the COVID-19 pandemic and a sense that the current government views foreign workers unfavourably. Increased bureaucratic requirements along with processing delays at Immigration NZ are also limiting the potential supply of workers from overseas. Despite the government’s expansion of its “green list” of favoured occupations in August, it remains difficult for most employers to try and access workers from offshore.

Our net migration outlook is little changed from the one we published in July. We forecast that net migration will hold between zero and -10,000pa between now and the end of 2023. At this stage, the risks to this forecast appear to be on the upside, with solid numbers of foreign arrivals over the last four months, and no guarantee that the upward trend in monthly Kiwi departure numbers will continue as strongly as our forecasts imply. Our net migration forecasts by citizenship are shown in Graph 3.

Graph 3

The weaker economic outlook has led us to take a slightly more cautious approach to the forecast pick-up in net migration during 2024 and 2025, with total migration over the two years predicted to be about 8,800 lower than we had previously expected. Nevertheless, net migration is forecast to climb to almost 17,000pa by the end of 2024 and almost 30,000pa during 2026. A change of government following the 2023 election could accelerate the increase in net migration, although we would expect any policy changes to take at least 12 months to have a noticeable effect on migration outcomes.

Central banks around the world are rapidly increasing interest rates following a period of over-stimulus, in terms of both monetary and fiscal policy, during the COVID-19 pandemic. As a result, New Zealand’s economic slowdown is coinciding with a period of weakening growth prospects globally.

Big increases in interest rates are having a significant negative effect on demand conditions across the US and Europe. Europe’s woes have been compounded by the conflict in Ukraine and high energy prices, while the UK’s new Prime Minister seems to have immediately entered self-destruct mode by announcing tax cuts that will require an additional £45b of borrowing, coming on top of subsidies to prevent household energy bills from rising, which could cost as much as £100b. Taken together, the two policies represent almost 7% of British GDP, and come at a time when UK government debt is already elevated due to support and stimulus during the COVID-19 pandemic. Subsequent announcements have rolled back some of these proposed changes, leaving everyone unaware of the ability of policymakers in the UK to achieve tangible outcomes.

Spooked international investors are fleeing for safety, with the higher interest rates being implemented by the US Federal Reserve attracting funds to the greenback. The other traditional “safe haven” currencies are not being supported, with the euro hampered by the Ukraine conflict, while investors are shunning Japan given the improbability of interest rate rises there any time soon.

The slowdown in the global economy has negative implications for New Zealand export incomes over the next couple of years, However, two factors are helping cushion the effects of the slowdown on exporters. Firstly, the weaker exchange rate is mitigating the extent of export price declines in New Zealand dollar terms. Secondly, the Ukraine conflict has disrupted parts of the international food supply chain, meaning that the downside risks to many of New Zealand’s export prices are less pronounced than for hard commodity prices.

Despite the challenges faced by the export sector, export volumes are set to rebound during 2023 and 2024, particularly as tourism recovers from the pandemic. Total export volumes in the year to June were down 18% from their pre-COVID level in 2019. Although we do not forecast exports to surpass their 2019 peak until 2026, we forecast that the pick-up in exports will add as much as two percentage points to GDP in 2023, with contributions of 1.0-1.5 percentage points during 2024 and 2025.

We have not included in our forecasts the implications of nuclear weapons being deployed in the Ukraine conflict. The fact we need to include this statement is absurd, but despite the threat of mutually assured destruction having previously made the use of nuclear weapons extremely unlikely, the entire Russian invasion of Ukraine to date has seemed to lack rationality. Hence the risk of nuclear weapons being used is now probably more elevated than ever. Having noted in our early February 2022 forecasts the risk of a Russian invasion, we point out this risk of nuclear weapons as a clear threat, but hopefully one that does not eventuate.

Although the economic implications for New Zealand might be well down the list of people’s concerns if a nuclear strike took place in Ukraine, the global panic is likely to have major negative implications in terms of financial markets and exchange rates, as well as growth prospects for our exporters and economy more generally.

GDP growth of 1.7% between the March and June quarters was stronger than we had expected. This momentum was essentially due to the bounce in exports and, in tandem with positive contributions from exports outlined above, is the primary reason for an upward revision to our GDP forecasts through until mid-2023. The outlook for almost every other element of economic growth has been revised lower.

The effects of tighter monetary conditions and the struggling world economy really become apparent in our GDP forecasts in 2023/24. Graph 4 shows that we expect economic growth to slip below 2%pa in the second half of next year and get as low as 0.9%pa during 2024.

Graph 4

The dichotomy between the export sector and domestic economic activity looks set to be even more stark than we envisaged in our July forecasts. We predict that domestic activity will grow by an average of just 0.8%pa during 2023 and 2024 as higher interest rates and weaker demand conditions take their toll on household spending and business investment activity. Growth in government spending, which has been a big factor behind the economy’s expansion over the last couple of years, is also set to slow significantly. Reduced profitability for farmers will have negative flow-on effects for many provincial regions

Together, these forces buffeting the economy are designed to cool the fires driving growth enough to rein in inflation. Slower growth is the target of higher interest rates, not a by-product from them. So until pricing pressures are better under control, short-term growth will need to be sacrificed for longer-term stability.