NZ economy locked into a downturn

A 0.6% decline in GDP in the December 2022 quarter is set to be followed by further contractions throughout the first half of this year, meaning that New Zealand is already likely to be in recession. Significant infrastructure repairs following Cyclone Gabrielle will provide a limited boost to growth, but sluggish consumption and exports will drive economic activity lower. Interest rates are nearing their peak, but the Reserve Bank appears hell-bent on squashing inflation before easing up on the brakes.

Although an influx of migrants is starting to improve the supply of workers in an incredibly tight labour market, overall inflation remains strong due to broad and sustained price pressures. Economic growth is forecast to average just 0.8%pa during 2024 and 2025 as higher interest rates and unemployment weigh on household spending.

Cyclone Gabrielle in mid-February caused significant damage to the northern and eastern parts of the North Island. The most severe damage occurred in Hawke’s Bay and Gisborne, but there were also significant effects in Auckland and Northland.

We see four broad effects of the cyclone on economic activity.

• Immediate small negative effect: activity was immediately hit during the cyclone and in the days following as businesses were unable to operate due to the weather, a loss of power and communications, and damage to and closure of transport routes. Horticultural production and exports from Hawke’s Bay and Gisborne will also be negatively affected by the loss of crops due to the cyclone, and damaged transport infrastructure will potentially have affected other primary production.
• Short-term small positive effect: Once the flooding had subsided, short-term repair and recovery work will have boosted activity in specific industries. Immediate repair work to infrastructure and buildings to make them serviceable is an obvious area of activity, and other flood relief and assistance work provided by the government will also have mitigated the cyclone’s immediate negative economic effects.
• Medium-term moderate positive effect: After short-term repairs, attention will turn towards longer-term rebuilding work. More than 4,000 homes were red- or yellow-stickered around the country following Cyclone Gabrielle and late January’s Auckland floods, with Auckland’s numbers representing about two-thirds of the total. We estimate that infrastructure repairs and replacement could cost close to $4b.
• Long-term small negative effect: Damage to land and the horticultural “capital stock” will have effects lasting beyond this summer. Replacements for destroyed grape vines and apple trees will take several years to resume production, with new apple trees taking 5-10 years before they start producing fruit.

The effects on Hawke’s Bay and Gisborne are significant, and we are still broadly comfortable with our view that the damage is closer to the scale of the 2016 Kaikōura earthquake, and then some. As we made clear in the early stages of the events, initial fears that the cyclone was a disaster on the scale of the 2011 Christchurch earthquake are far overblown. As a comparison, there were about 150,000 damaged homes in and around Christchurch following the earthquake, with 30,000 sustaining more than $100,000 of damage. The damage caused by the cyclone and flooding is much patchier and more localised than the earthquake’s destruction.

Our estimates of infrastructure activity could also be too high. The repair bill for State Highway 1 and the main trunk rail line following the Kaikōura earthquake was about $1.2b, with the road taking 13 months to reopen after the quake (although work continued until late 2020). In comparison, State Highway 5 took about five weeks to reopen after Cyclone Gabrielle, and State Highway 2 between Napier and Wairoa is expected to be closed for three months.

In both cases, after reopening, the roads will not be fully operational immediately. There will be ongoing repair work and, in some places, major remediation, reconstruction, or rerouting of the roads, which could continue for several years. Furthermore, there is also significant damage by the cyclone and floods to roads in Auckland, Northland, and Thames-Coromandel, that will add to the overall infrastructure repair bill. Nevertheless, we remain unsure whether the cost of this work will reach $4b and, even if it does, how much displacement of other infrastructure activity will occur as funds are diverted away from other projects.

The other major economic development over the last couple of months has been the banking troubles in the US. The collapse of Silicon Valley Bank and Signature Bank led to fears of a broader bank run, but quick action by the US Treasury helped to reassure investors and seems to have led to a stabilisation in financial markets.

Nevertheless, an air of uncertainty has persisted, encouraging the US Federal Reserve to veer away from a sharper tightening in monetary conditions at its most recent meeting in late March. Despite the persistence of inflation in the US, the Fed is conscious of the risks to future economic growth posed by a substantial reduction in the availability of credit. At this stage, the recent bank failures appear unlikely to develop into a full-blown repeat of 2008’s Global Financial Crisis, but the Fed is now treading a cautious line between controlling inflation and exacerbating the stresses present in the banking sector.

It is unclear whether the banking troubles will lead to downward revisions to global economic growth forecasts. For now, expectations for global growth appear to have stabilised. Growth prospects for 2023 and 2024 remain relatively soft, but the trend of deteriorating forecasts that persisted throughout 2022 seems to have levelled off.

China’s economy has good momentum following the government’s departure from its zero-COVID policy. There were concerns that the Chinese economy could continue to be severely disrupted throughout the first half of this year as COVID-19 spread through the relatively low-immunity population. However, domestic economic indicators have begun the year positively. Although the Chinese economy is likely to be hampered this year by softer export activity, which reflects weaker demand conditions in the US and Europe, less disruption due to COVID-19 means that GDP growth is still likely to come in above 5%pa during 2023 and 2024.

New Zealand’s banking sector has not been directly affected by the offshore ructions. The Reserve Bank’s recent statements reinforce the stability of the New Zealand banking system, and they are backed up by regular stress tests of key banks. Financial market risk aversion has seen the New Zealand dollar pushed downwards, and longer-term interest rates have also been driven lower. Both these movements represent something of an easing in monetary conditions, with the weaker exchange rate helping exporters, and lower long-term interest rates have created an environment of easing retail interest rates.

This easing in retail rates threatens to undermine the efforts of the Reserve Bank to tighten monetary conditions and squeeze demand into a position where it is in better balance with supply. In response, the Reserve Bank has pushed against market views of limited further increases to the official cash rate (OCR) and continued on a more aggressive path. The OCR is now at 5.25%, and there are limited signs of any easing in inflationary or economic pressures.  

In November, we lifted our pick for the OCR’s peak to 5.75%, and we maintained that view in our early February 2023 forecasts. After the February 2023 Monetary Policy Statement, we had pared our expected peak back to 5.50%, but the recent stronger action by the Reserve Bank has led us to reaffirm the higher peak of 5.75% (see Graph 1).

Graph 1

Despite caution from some quarters about GDP numbers published by Stats NZ showing the New Zealand economy finished 2022 less strongly than had been anticipated, the Bank has been forced to raise the OCR further and faster given that retail interest rates were moving against the Bank’s goals. Nevertheless, the strong upward trend in the OCR raises concerns that the Reserve Bank is overdoing its tightening in monetary conditions, leading to some calls for fewer interest rate rises this year.

We think that much of the heavy lifting has already occurred in the interest rate space, with a waiting game developing until higher interest rates affect household spending to the maximum degree. Yet the economy is still operating well beyond its sustainable capacity, and there is little sign that inflation, the Bank’s primary policy target, is moderating yet. We cannot rule out a scenario where the Reserve Bank needs to increase the OCR beyond 5.75%, and we also expect it to take longer for interest rates to start moderating into 2024.

Although the effects of Cyclone Gabrielle on economic activity are, generally, relatively small, the aftermath of the floods will have a noticeable effect on inflation outcomes. Fruit and vegetable prices, in particular, have been pushed higher by the loss of crops, adding to the pain being felt by households at the supermarket. The need for immediate repair work is also likely to have an effect on building costs in Hawke’s Bay and Gisborne as the construction industry in these regions struggles to meet demand.

Residential rents and construction costs also rose substantially in Canterbury in the two years following the 2011 earthquake. Although the overall effects of the Auckland floods and Cyclone Gabrielle appear to be nowhere near as large, we still expect to see a similar phenomenon in Hawke’s Bay and Gisborne. The additional complication this time is that cost pass-through and inflation expectations are already heightened.

The cyclone has been a contributing factor to the upward revisions to our inflation forecasts over the next two years. Expectations of inflation expectations and pricing behaviour being sustained at a higher level for longer have also influenced the outlook. Feedback from our discussions with businesses indicate that domestic transport costs remain problematic and that upward pressure on labour costs is still significant. Even with the assumption that the government keeps its reductions to fuel excise duty and road user charges in place beyond June, we now expect inflation to remain stronger for longer.

Graph 2 shows that we now expect inflation of 6.6%pa at the end of 2023 and 3.8%pa at the end of 2024. It could be mid-2025 before inflation is back within the Reserve Bank’s 1-3%pa target band.

Graph 2

Net migration has whipsawed since the borders fully reopened in July last year. The annual net flow had edged up from -19,757 in February 2022 to -13,398 by July, but it has since surged to a net inflow of 33,157 by January 2023. Arrival numbers in the last three months totalled over 54,600, not far short of the 60,400 recorded in the three months to February 2020, when many people got unexpectedly stuck in New Zealand due to the borders subsequently closing.

With migration already exceeding the annual net inflow we thought would be managed any time within the next five years, the momentum in foreign-citizen arrivals has meant we have again had to significantly revise up our migration expectations over the next two years. The government’s immigration Green List and the restoration of processing capacity at Immigration NZ have seen work visa approval numbers soar and arrivals are following suit. We now expect the net migration inflow to climb above 57,000pa in the second half of this year, before gradually easing to about 32,000pa by the end of 2024 (see Graph 3).

Graph 3

It's something of an act of faith that net migration will ease during 2024. We believe the current rapid inflow of migrants represents a catch-up in the supply of foreign workers following the pandemic, with businesses looking to rapidly fill key skills gaps and labour shortages now that they have greater access to workers from offshore. Because of this catch-up dynamic, we do not expect the extra-large influx of foreign workers to be sustained beyond this year. A tapering of the inflow numbers would be similar to the levelling off in the NZ-citizen departure numbers that has occurred since mid-2022, as the number of Kiwis heading overseas has failed to keep increasing as much as the initial rush would have suggested.

The other key factor that continues to influence our migration outlook is the looming slowdown in the economy. We forecast the unemployment rate will reach 4.3% by the end of this year and almost 5.0% by mid-2024, a deterioration in the labour market that will naturally lessen both the demand for foreign workers and the appetite of migrants to come to New Zealand to work. Against this backdrop, foreign-citizen arrivals are expected to ease from 129,000pa in September 2023 to as low as 84,000pa by mid-2025.

We’d note that migration trends at present are even more difficult to discern than the usual data, which can be highly volatile and difficult to understand. But we cannot deny the recent pick-up in arrivals coming through in official estimates, even acknowledging that revisions will undoubtably be made to the figures. The question for the future is how migration trends will shift, and when potential government policy changes are thrown into the mix, our migration forecasts from 2024 onwards remain incredibly uncertain.

The combination of higher net migration and cyclone recovery work mean that our GDP forecasts are a little less downbeat than the ones published in February. We now expect the economy to shrink by 0.1% over the year to March 2024, compared with a 0.4% contraction for the June 2024 year in our previous forecasts. A three-quarter recession through to June 2023 is less severe than the five quarters of negative growth we had previously picked between December 2022 and March 2024.

Even so, this revision does not mean that economic conditions will be particularly upbeat during 2024 and 2025. GDP growth during these two years is forecast to average just 0.8%pa (see Graph 4), as households grapple with higher mortgage rates and the weaker labour market. Both these influences will have lingering effects on households’ discretionary spending, negatively affecting both the amount available and the willingness to get out and spend.

Graph 4

The reality is that the New Zealand economy continues to face a period whereby demand moderates to come back in line with supply. Insipid growth over a two-year period is needed to correct the imbalances that have manifested themselves across a wide range of indicators, from the housing market, to the current account deficit, and inflation outcomes. The economic roller-coaster is already descending from its pandemic-stimulus highs, and we recommend being firmly strapped in because the length and steepness of the correction is far from certain.