Sustained inflation makes recession inevitable

Inflation continues to be more persistent than had been previously expected, and so we continue to expect the Reserve Bank will lift the official cash rate to 5.75% in the first half of this year to soften demand. As household spending is squeezed by higher mortgage rates, businesses will start to reassess their staffing needs, and we forecast that the unemployment rate will push above 4% in the second half of 2023 and reach 5% by late next year. These job losses will further weigh on household spending. We predict that annual GDP will contract 0.4% in the year to June 2024, and the economy will struggle through a period of flat or falling quarterly activity that could persist until mid-2025. A likely global recession presents additional downside risks to our already negative forecasts.

On a more positive note, most of the supply constraints and disruptions that have plagued the last three years appear to be diminishing. Between this change and the effects of sharply tighter monetary policy on demand, we are hopeful of a moderation in inflation that will enable the Reserve Bank to start cutting interest rates by mid-2024.

Over the last five months, the Reserve Bank has shown a more single-minded focus on taming inflation than had been apparent previously. Strongly worded and hawkish statements in October and November were backed up by a lift in the official cash rate of 75 basis points to end 2022, and a strong forward track for further interest rate rises during 2023. The Bank’s forecast of a contraction in GDP epitomised a departure from the “softly, softly” approach previously favoured by the Bank as it unwound the monetary stimulus implemented during the pandemic. Other considerations, such as a rise in unemployment [1] or a more prolonged period of house price falls, have been put aside in the pursuit of price stability.

The reality is that the current series of large interest rate rises will amplify New Zealand’s economic cycle over the next two years. The downswing in economic activity during 2023 and 2024 represents a reversal of the excessive and unsustainable growth that occurred during 2021 and 2022 due to massive monetary and fiscal stimulus. A quicker response to the burgeoning inflation problem in the second half of 2021 and early 2022 might have reduced the need for such a large increase in interest rates now. However, the requirement for a circuit-breaker to inflation expectations and pricing behaviour means the Bank is now left with little choice but to negatively shock the economy.

We are forecasting that this shock will amount to economic activity contracting in five out of six quarters between December 2022 and March 2024. This contraction represents a prolonged recession for New Zealand, although growth is not expected to be as deeply negative as it was in 2008 and 2009 during the Global Financial Crisis. Even so, the prolonged effects of the tightening will take time to be felt fully by the economy, meaning that a genuine pick-up in growth after the downturn could be as far away as late 2025 (see Graph 1).

Graph 1

Our recent From the beach 2023 provides a detailed history of recessions in New Zealand and the rationale behind the need for weaker economic growth over the next 18 months.

The initial transmission of official cash rate increases through to effects on household budgets has been slow and concentrated among a relatively small proportion of households. Nevertheless, a 3.5% reduction in quarterly private consumption spending between March and September 2022 suggests that the Reserve Bank is starting to get some traction with its tightening. Growth in spending volumes has also been dampened by high fuel prices, providing less money for discretionary spending, as well as broader price rises that have left consumers getting less bang for their buck.

Further rises in the official cash rate will take place until mid-2023, with the flow-on effects into household budgets taking another 6-12 months to be fully realised due to the predominance of fixed mortgage lending. This reduction in household demand is a key outcome of the higher interest rates being implemented by the Reserve Bank. Household spending represented 62% of economic activity over the last year, so any sort of slowdown in GDP growth is almost impossible to achieve without dampening consumers’ appetites.

With an unemployment rate of 3.3%, the labour market is still tight at this stage. Recent survey data has suggested some softening in businesses’ employment intentions, but it is likely to be mid-2023 before more definite signs of an easing in the labour market start to appear. Once an upward trend in unemployment starts to develop, consumers will become more nervous about their income security. Job losses will directly weigh on spending as people’s incomes are affected, but the indirect effect is arguably more important, as more workers become concerned about how far unemployment might rise. We expect a lift in the unemployment rate towards 5.0% (see Graph 2) will continue to weigh on spending during the first half of 2024, even if the Reserve Bank starts to lower the official cash rate by the middle of next year.

Graph 2

The result is a 1.0% contraction in household spending during 2023 and barely positive growth during 2024 (see Graph 3). The next two years will be particularly difficult for businesses selling to the consumer sector, especially when compared with the post-COVID surge in spending, or the lift in spending during the second half of last decade fuelled by rapid population growth.

Graph 3

Some commentators have started to describe New Zealand’s current performance as “stagflation”, harking back to the experience during the 1970s when the economy experienced persistent inflation alongside a lack of GDP growth.

To put things in perspective, it’s worthwhile dragging up the data from that period. Between 1975 and 1980, New Zealand’s GDP barely changed, with economic growth averaging just 0.03%pa. At the same time, consumer price inflation averaged almost 15%pa. Even during this period, there was arguably some responsiveness in inflation to the lack of economic growth, but it was very limited – inflation eased from 18%pa in mid-1976 to 10%pa by the end of 1978. The persistence of high inflation would continue to haunt New Zealand throughout the 1980s as well.

Against this benchmark, New Zealand’s current mix of temporarily faster inflation and a looming recession cannot, and should not, be labelled “stagflation”. Our forecast of 18 months without further economic growth pales in comparison beside the five-year stagnation in the 1970s, and a peak inflation rate of under 7.5%pa is about half the average rate sustained during the second half of the 1970s.

Perhaps the biggest similarity between the two periods is the role that supply shocks have played in generating higher inflation. In the 1970s, the oil price shocks pushed up inflation and constrained the economy’s ability to grow. This time around, disruptions to global manufacturing, higher international shipping costs, increased oil prices due to the Russian invasion of Ukraine, and domestic labour shortages due to closed borders have contributed to the inflation spike and constrained economic growth. However, these drivers have mostly been relatively temporary, and they are now being resolved. They have also not been the only factors driving higher inflation, with massive monetary and fiscal stimulus creating very strong demand conditions at the same time.

In our view, the current coincidence of no economic growth and moderately high inflation is mostly a matter of timing. Given the lift in inflation expectations over the last 1-2 years, it will take time for the Reserve Bank’s tightening in monetary policy to jolt businesses’ pricing behaviour. Firms have got sucked into more of a cost-plus mindset than has prevailed for the last 30 years, and a definite weakening in economic activity will be necessary to change that approach and sharpen competitive pressures around pricing again.

The near-term persistence of cost and price pressures have led us to revise up our inflation forecasts throughout 2023. The removal of the temporary reduction in fuel excise duty and road user charges at the end of March will cause a temporary spike in inflation back up to 7.2%pa in the June 2023 quarter, and annual inflation is expected to still be up at 5.6% at the end of this year. [2] However, Graph 4 also demonstrates that the tougher monetary policy stance being taken by the Reserve Bank will bear fruit by the second half of 2024. We have revised down our forecasts for inflation between mid-2024 and the end of 2025, with the Bank getting inflation back within its 1-3%pa target band by the December 2024 quarter.

Graph 4

One of the areas with the longest lags between policy implementation and real economic outcomes is the labour market. Our unemployment rate forecasts in Graph 2 . show that genuine spare capacity in the labour market will only start to emerge in the second half of this year, once the unemployment rate climbs above 4%. It is likely to take even longer for wage growth to reflect this shift, and we expect many businesses will not want to risk losing their best staff. In an environment where the cost of living has been rising rapidly, we expect wage inflation to hold above 6%pa until mid-2024. Although firms will have decreasing scope to simply pass on any cost increases they face, ongoing wage pressures will be one area that will continue to cause headaches around profitability and pricing behaviour.

Even in the labour market, though, there is emerging evidence that some of the most critical pressures are easing. Last July’s border reopening and the government’s immigration Green List have led to a faster-than-expected rebound in arrivals of foreign citizens. Job ad levels have moderated too. Specific skills gaps are now able to be filled more readily, and firms are enjoying more “normal” access to workers from overseas.

We now expect foreign citizen arrival numbers for 2023 to average 80% of their 2018 level, helping sustain total annual net migration of 16,300 this year (see Graph 5). This improving supply of labour will help bring wage inflation down during 2024, particularly given the prolonged recession will mean that growth in demand for workers will be very limited.

Graph 5

Following the December quarter consumers price index result, which showed inflation plateauing at 7.2%pa, we expect the Reserve Bank to increase the official cash rate (OCR) to 5% this month. Graph 6 shows that we forecast further increases will take the OCR to 5.75% by mid-2023.

Graph 6

Given the hawkish tone of the Bank’s statements in late 2022, it would be surprising if the Bank failed to follow through with interest rate rises in line with its forecasts published last November. The Bank needs to act strongly to continue restoring its inflation-fighting credibility, especially given there is little evidence that cost and price pressures are being brought under control yet. Smaller increases in the OCR than we are forecasting would either require the Bank to suddenly become much more dovish in its outlook, or place much more weight on changes in future economic conditions than we have seen over the last two years.

Beyond this near-term peak in the OCR, we see the risks to our interest rate forecasts as being on the downside, for the first time in a couple of years. Our forecast predicts that the OCR will be reduced from 5.75% to 4.5% by the end of 2024 and to 3.5% during 2025. However, the development of spare capacity within the New Zealand economy though the upcoming recession could encourage the Reserve Bank to cut interest rates more quickly during 2024, particularly if pricing indicators and inflation outcomes are also more favourable.

New Zealand’s recession comes against the backdrop of a global economy also facing recession. The drivers of the international downturn are much the same as we are experiencing in New Zealand: rapidly rising interest rates, the withdrawal of fiscal stimulus as the COVID-19 pandemic ends, and supply shocks caused by the Russian invasion of Ukraine. The risks to our outlook for New Zealand’s economic growth over the next 18 months lie to the downside, if the global recession hits our economy harder and faster than we have allowed for.

In the US, the Federal Reserve is set to slow the pace of interest rate increases and could lift the Fed funds rate as little as another 75 basis points before pausing or ending its tightening cycle. But the lagged effect of these higher rates will take time to fully work through the economy, and year-end economic growth is expected to be close to zero in 2023.

Europe’s interest rate increases have been less marked, but the region has been hit harder by the surge in energy prices associated with the Russian invasion of Ukraine. Although oil prices have eased somewhat, this decline reflects weaker expected demand, rather than any resolution of the supply-side factors. Like the US, Europe is forecast to record little or no economic growth this year. Gas shortages in Europe are now expected to hit harder in 2024 than this year.

Probably the biggest positive for the global growth outlook in recent months has been China’s abandonment of its zero-COVID policy. In the near-term, the spread of the virus throughout the country’s population, which has a relatively low level of immunity, could continue to cause disruption in terms of both production and demand levels. However, the government’s shift away from lockdowns provides greater certainty about activity over the medium term, and it has led to a little more optimism creeping into Chinese economic growth forecasts for 2023 and 2024. A more stable outlook for Chinese activity will also benefit other economies throughout the Asian region.

Even so, the broader global downturn will weigh on industrial production and economic activity for manufacturing-based economies such as China, South Korea, and Taiwan throughout the next 12-18 months. New Zealand’s food-based exports will be less affected by this weakness than harder commodities, but we still anticipate some downward pressure on export prices in coming quarters.

The good news on the trade front is the substantial reduction in international shipping costs that has occurred in recent months. Indices of container shipping costs are now down as much as 80% from their late 2021 peaks (see Graph 7). Although the various indices are still 45-70% above their 2019 averages, paying freight rates of 1½ times pre-pandemic levels is a vast improvement on the rates that were 7-8 times normal in September 2021.

Graph 7

The reduction in costs for shipping between China and Australia-NZ is taking about a month longer to come through than for other routes. We also note that many importers will be locked into existing contracts that could be several months away from renegotiation. Nevertheless, the substantial decline in freight costs is providing major relief for importers and will continue to do so throughout 2023 and 2024.

Improvements in the cost, availability, and reliability of international shipping will also be welcome news for exporters, who have had to grapple with significant disruptions over the last three years.

The decline in shipping costs is representative of improvements in supply-side issues that have negatively affected the world economy over the last three years. International production levels will be more stable, especially with the end of lockdowns in China. Labour shortages in New Zealand will become less acute as the inflow of foreign workers ramps back up. Only sustained higher energy prices appear likely to work against the normalisation of market conditions and, by extension, supply-side inflation over the next two years.

By the end of 2025, we expect inflation to have been quelled, dampened by the containment of the excess demand that has arisen in the economy over the last 2-3 years. Average economic growth of just 0.4%pa over the three years to December 2025 provides a clear indication of this reduction in demand. An unemployment rate of around 5% also demonstrates that some spare capacity will have arisen as part of the Reserve Bank’s efforts to get inflation under control.

Economic growth will accelerate during 2025 and 2026 as households adjust to lower interest rates and a stabilisation in the labour market. However, we expect GDP growth to remain relatively muted, reaching only 2.6%pa by the end of the forecast period in mid-2027. Interest rates will remain less stimulatory than they were between 2015 and 2020, there will be little scope for sizable increases in house prices, and fiscal policy is likely to remain relatively tight given current government debt levels. The economy should be through its post-COVID hangover in three years’ time, but the appetite for then starting another spending binge should be limited.

 

 

[1] The Bank stated in November that “employment is beyond its maximum sustainable level,” so a rise in unemployment is consistent with bringing the labour market back into balance. However, an unemployment rate forecast of 5.7% by March 2025 clearly demonstrates the Bank’s belief that it temporarily needs to get employment below its maximum sustainable level to ensure inflation is brought back within the 1-3%pa target band.

[2] Our forecasts were finalised before the government’s announcement of the extension of the subsidies for fuel excise duty, public transport fares, and road user charges to the end of June 2023. Extending the subsidies for the first two items will remove about 0.1 percentage points of inflation from the March quarter result and about 0.8 percentage points from the June quarter result. If the subsidies are not extended beyond June then the September quarter inflation result will be commensurately higher. The extension of the road user charges subsidy will also delay flow-on effects of higher transport prices into inflation for other goods and services.