A mild recession as interest rates quell inflation

After 18 months of interest rate rises, the wait for the real effects to start showing through in the economy looks like it is ending. Economic activity has contracted as budgets are squeezed, government spending has also pulled back slightly from its peak, and, most importantly, both inflation and inflation expectations are easing.

The shadow of higher mortgage rates continues to hang over homeowners as their previous much-lower fixed rates come up for renewal. Paradoxically, though, analysts are increasingly anticipating that house prices will bottom out in the near future. Probably the most significant part of the economy that has shown few signs of turning yet is the labour market, but the big surge in migrant arrivals should slow wage growth and lead to an increase in the unemployment rate in coming quarters.

We continue to expect quarterly GDP growth to average close to zero over the next year, meaning the economy will continue to feel recessionary through until about mid-2024. Outcomes for individual households will feel more negative than overall economic activity given the positive effects of strong population growth on aggregate demand. Household spending will be squeezed by higher mortgage rates, continued cost-of-living pressures, and a softening labour market. By mid-2024, inflation will have clearly moderated and the Reserve Bank will start to reduce interest rates.

Let’s start with inflation. The 1.2% increase in the consumers price index in the March quarter was smaller than any forecaster was predicting, ending a run of about two years where inflation had exceeded market expectations, often significantly. The result was particularly good in the context of specific food price pressures created by the Auckland floods and Cyclone Gabrielle, as well as previous indications that labour shortages might be causing a broadening of price pressures across a range or service industries.

Graph 1

Graph 1 shows that the easing of inflation in the March quarter has been followed by a moderation in inflation expectations, as captured in the Reserve Bank’s Survey of Expectations. Although short-term inflation expectations tend to be heavily influenced by current inflation outcomes, the Reserve Bank regards the two-year-ahead measure as a good indicator of future inflation outcomes. Apart from the kneejerk response in June 2020 when COVID-19 hit, the dip in two-year expectations from 3.3% to 2.8% was the largest single-quarter movement since 1991.

Our own discussions with businesses suggest that, although cost pressures have not completely disappeared, they are less acute than they were even at the end of 2022. Many businesses are now more concerned about the expected weakening in demand conditions than about the continuous cycle of cost increases they had been grappling with. If anything, the advent of weaker demand is making it more difficult for firms to pass on cost increases to their customers and, in the retail sector, is leading to a pick-up in discounting compared to what has been seen throughout the last three years.

Taken together, these factors suggest we are now past the worst of the inflation spike. Offshore, we have seen international shipping costs returning towards normal, supply chain disruptions easing, and weaker global growth taking the heat out of demand pressures. These reduced global price pressures, in tandem with signs of easing domestic inflation, augur well for inflation outcomes over the next 24 months.

Possibly the biggest remaining inflation risk is the return of full road user charges and fuel excise duty that took place at the start of July. Although the 29c/L increase in petrol prices will initially push up the CPI, it’s second-round effect will reduce household spending and aggregate demand, even if the rise of electric vehicles means that higher petrol prices have a less pronounced deflationary effect than they would have previously. More critically, the increase in road user charges will place upward pressure on freight costs for all goods being transported around the country.

We have allowed for a 1.9% quarterly increase in the consumers price index in the September quarter because of the reinstatement of these higher government charges. But with evidence that underlying inflationary pressures are easing, our inflation forecasts remain considerably lower throughout 2023 and 2024 than the ones we published three months ago. Inflation is expected to have eased to 5.2%pa by the end of this year and 3.0% by the end of 2024 (see Graph 2).

Graph 2

At its Monetary Policy Review in May, the Reserve Bank signalled that the official cash rate (OCR) is now on hold, at 5.5%. For many of the reasons outlined above, the Bank thinks it has now done enough to quell inflation.

Our central forecast is for no further increases to the OCR from its current level (see Graph 3). However, if inflation remains higher than expected, and these pressures are reinforced by other indicators, there is a risk that the OCR could be increased again, but not before November this year.

Graph 3

In our view, it will take six months before there is sufficient evidence for the Bank to change its mind and decide it needs to lift interest rates further – if indeed a further rise is needed at all. The Bank will be looking for a weakening trend in the major indicators of inflation, unemployment, and GDP between now and the end of the year. These indicators would probably need to be stronger than expected for two quarters in a row to convince the Bank that the lagged effects of previous interest rate rises were not slowing the economy enough.

Beyond this peak in the OCR, we have pencilled the first interest rate cut in May 2024, with the OCR gradually being lowered to 4% by the second half of 2025. The timing of the first interest rate cut depends on how comfortable the Reserve Bank is in reducing the OCR while inflation is still outside its 1-3%pa target band. Our forecast of a 0.6% quarterly change in the consumers price index in March 2024 would be the first quarterly increase below 0.8% since 2020 which, when published in April next year might be sufficient to convince the Bank that inflation is safely heading back inside the target band.

Although we have yet to observe a significant easing in the labour market or wage inflation (indicators that usually are the last to turn), inflationary concerns in the labour market are likely to dissipate throughout the next 12 months. The massive migration influx has led to an improvement in the availability of workers, with the critical skills shortages that constrained business growth during 2021 and 2022 starting to ease. Employment growth has accelerated since the start of this year as firms have filled longstanding vacancies, even as employment intentions have weakened.

We expect employment growth to slow during the second half of this year as the catch-up in hiring is superseded by caution around future demand conditions. Wage growth will moderate – the biggest pay increases have been associated with headhunting and worker poaching, which is already becoming less commonplace. A slowing inflation rate will also start to see workers’ expectations of pay increases lessen as cost-of-living pressures become less acute.

Although we forecast the unemployment rate to rise from 3.4% currently to 5.0% by September 2024 (see Graph 4), this increase is only based around a limited number of job losses or redundancies. The bulk of the rise in unemployment will result from job creation not keeping pace with population growth.

Graph 4

Less tightness in the labour market should naturally start to act as a dampener on migrant arrival numbers throughout the next year. After topping 20,000 in both February and March, arrival numbers pulled back to just below 17,000 in April. It’s hard to be overly certain about one month’s data (especially given regular revisions to the data), but the April numbers might signal that the rush of foreign hiring following the border reopening in mid-2022 is now starting to moderate.

Graph 5

We forecast that annual net migration will peak at over 93,000 in the second half of this year, pulling back to below 38,000pa by the end of 2024. The stronger-than-expected arrival numbers this year will add about 30,000 more people to the population than we had previously been forecasting. However, Graph 5 also shows that the outsized arrival numbers now could lead to lower net migration in 2026, as more people leave the country when their three-year visas expire.

Although stronger immigration is alleviating labour shortages and associated cost pressures, the influx of migrants will also add to aggregate demand. The matching of the skills of arrivals with gaps in the New Zealand labour force is much better than it was 20-30 years ago, when immigration was widely regarded as having inflationary effects for 6-12 months before migrants were properly integrated into the workforce. However, there remains a risk that the demand pressures associated with the surge in arrivals could mean that inflation eases more slowly than expected.

Perhaps the biggest demand risks related to the migration surge are associated with the housing market. The Real Estate Institute’s index shows that house prices have retreated 17% from their peak in November 2021, but they are still 21% higher than at the end of 2019. Housing remains highly unaffordable, but the rapid turnaround in population growth threatens to put a floor under house prices sooner than would otherwise have occurred.

With interest rates also peaking at a slightly lower level than we had expected, the outlook for house prices is slightly less negative than in our previous forecasts. Some analysts are already talking about the housing market bottoming out, backed up by sales volumes in April and May that have been a bit stronger than the prior six months. Although we see house prices bottoming out a little higher than in previous forecasts (see Graph 6), we expect mortgage rates to continue to be a significant constraint on the borrowing and debt-servicing ability of potential buyers. As a result, we do not expect house prices to be bid up significantly from current levels, with house price inflation averaging just 2.2%pa between mid-2024 and the end of the forecast period.

Graph 6

Amid the sentiment around a soft landing for the New Zealand economy, it might seem surprising that our forecasts of GDP growth throughout 2024 are lower than they were in April (see Graph 7). This change is partly a matter of timing, with the surprising and somewhat implausible 2.4% quarterly increase (seasonally adjusted) in private consumption in the March quarter effectively deferring some of the correction in household spending into subsequent quarters. Instead of our trough in private consumption growth occurring in December 2023, it has now been pushed out to June 2024.

Graph 7

There are other segments of GDP that are less positive in 2024 as well. The weak global economy, and China in particular, is set to weigh on exports. Commodity prices and goods exports have been weaker than expected, and they are a key factor behind overall export volumes growing by an average of just 4.2%pa during 2023 and 2024, rather than the 5.9%pa we had previously been forecasting. The sluggish global economy will also continue to act as a drag on the recovery in international tourism, notwithstanding the recent signs of an emerging rebound in visitor numbers from Asia.

Business investment is also set to be sluggish over the next 18 months, as firms take advantage of improved labour supply conditions and shy away from committing to major capital expenditure given higher interest rates.

Mitigating these areas of weakness during 2024 is a less downbeat outlook for government consumption spending. Despite prior talk of spending restraint and reprioritisation, the government’s Budget in May included increased spending and borrowing. As a result, we expect a 1.4% increase in government consumption during 2024, rather than the zero growth we had previously been forecasting.

Since the end of 2019, the New Zealand economy has grown by an average of 2.3%pa. Although this figure doesn’t really sound spectacular, the 1.4%pa growth in per-capita GDP over this period is only marginally below the 1.5%pa per-capita growth recorded during the second half of last decade. The biggest difference over the last three years has been the lack of population growth, averaging less than 1.0%pa, compared with 2.0%pa during the previous five years. Factor in the raft of shocks that have been thrown at the economy, and its performance looks to have been relatively good.

The economy might flirt with negative growth between now and late 2024, but the contraction will appear to be mild compared with the one following the Global Financial Crisis (GFC). However, the return of stronger population growth will mask the economy’s struggles over the next 18 months. Graph 8 demonstrates that per-capita GDP is set to contract by 2.2% in the year to June 2024, a significantly worse outcome than during the Asian Financial Crisis in the late-1990s, and little better than during the GFC or the lockdown-affected results in 2020.

Graph 8

A similar pattern is observed if we look at growth in private consumption. Household spending has grown 9.0% over the last year, but a lot of that increase in spending has been solely driven by price rises. Once the inflationary effects are stripped out of the numbers, consumer spending volumes have increased by a more modest 2.4%, but more recently that figure has been artificially boosted by more people coming into the country. By mid-2024, we forecast that the volume of household spending per person will have shrunk by 2.2% from a year earlier. This figure provides the clearest indication of the reversal in households’ fortunes as the economy has slowed, and it is a worse per-capita contraction than occurred during the GFC. The effects on businesses of each of their customers spending less will only be mitigated by an increase in customer numbers associated with strong net migration.

Graph 9

In summary, the economic downturn is now starting to hit. Although interest rates are close to or at their peak, and we do not forecast the unemployment rate to get above 5.2%, households will still feel the squeeze of more difficult conditions over the next 1-2 years. New Zealand’s growth prospects will also be hampered by the effects of a sluggish global economy on our export sector.

More positively, there are signs that inflation is being conquered and that the cost and pricing environment will return to something more normal by 2025. That trend provides a greater degree of assurance that interest rates will also start to ease next year.

Nevertheless, we remain cautious about some of the major imbalances in the economy. The large current account deficit looks likely to improve as tourism’s recovery continues, but our goods exports remain vulnerable to higher cost structures, more stringent environmental requirements, and the vagaries of Chinese demand. Housing is less overvalued than it was 18 months ago, but land and infrastructure supply issues are still significant, particularly in light of the breakdown of the bipartisan agreement about the Medium Density Residential Standards. And our seeming reliance on a larger population, rather than better productivity, to growth the economy, shows few signs of ending. These challenges all look set to persist beyond the downturn that will dominate people’s attention over the next 18 months.