Soft landing in store as inflation subsides

After easing more than had been expected in the September quarter, inflation is expected to continue slowing throughout 2024. However, higher transport costs threaten to limit the extent of that downward trend. Persistent tightness in the labour market, signs of a resurgence in house prices, and positive flow-on effects to household spending also add to risks of sustained demand-led inflationary pressure.

The election result provides for a period of limbo still, while the complex negotiation of government formation occurs. What is clear is that more restrained government spending is set to occur following the election result, while provincial economic growth is being undermined by falling export prices and much higher operating costs for farmers. The Reserve Bank looks unlikely to lift the official cash rate (OCR) above its current level of 5.5%, which will enable a softer landing for the economy, but also risks allowing inflation to persist outside the 1-3%pa target band for longer.

Inflation eased to 5.6%pa in the September quarter , its slowest rate in two years. The quarterly increase of 1.8% in the Consumers Price Index was a particularly good result given the 17% lift in petrol prices during the quarter.

The Reserve Bank’s Monetary Policy Review in early October saw it trying to thread the needle between near-term upside inflationary pressures and medium-term downside risks for the economy. We concur with the range of issues faced by the New Zealand economy that the Reserve Bank has identified, and the dip in headline inflation justifies the Bank’s signal that the OCR is unlikely to be raised in coming months from its current level of 5.5%.

Higher petrol prices in the September quarter were caused by the government’s reinstatement of the full rate of fuel excise duty, exacerbated by a sharp lift in international oil prices as production cuts by OPEC and its allies finally had a noticeable effect. On its own, this result would not normally worry the Reserve Bank. Although higher petrol prices push up the headline inflation rate from what it otherwise would have been, they also have a dampening effect on overall demand levels, because households have less money left over to spend on other goods and services.

The more concerning issue arising from higher oil prices is the effect on transport costs. Diesel prices have surged 26% higher since mid-July and are at their highest level since November last year. As occurred during 2022, refining margins are expanding again, compounding the effects of higher crude oil prices. With transport operators also hit with a 55% jump in RUC prices at the start of July, we see a risk of flow-on effects into the costs of all goods and services over the next 6-9 months. Although inflation is currently tracking in line with our July forecasts, these transport cost pressures mean that it could prove more difficult to bring back towards the Reserve Bank’s 1-3%pa target band.

We also note that non-tradable inflation remains stubbornly elevated in the latest figures, at 6.3%pa. These more persistent price pressures in the domestic economy will need to show clear signs of easing during 2024 if our forecast of inflation below 3.0%pa in early 2025 is to be achieved (see Graph 1).

Graph 1

In a sense, it’s remarkable that inflation is slowing as expected, even as the labour market remains tight (but getting slowly less tight) and economic the economy keeps growing. It seems that a normalisation of supply chains has helped lower imported inflation, although domestic inflation remains high and concerning.

Recent survey data, particularly the NZIER’s Quarterly Survey of Business Opinion, has suggested that workers are becoming less difficult for firms to find. A range of other indicators from the survey around labour turnover, overtime, and employment intentions, also suggest that the most acute labour shortages are behind us.

The easing in labour shortages is obviously being enabled by record high migration inflows (see Migrant arrivals have peaked, and more Kiwis keep leaving for more on migration). We have also previously written about the catch-up in employment that has been occurring as firms fill longstanding vacancies with workers from overseas, and how we expect that pent-up demand to fade in coming months. But to date, the labour market has shown no clear signs of turning. Growth in monthly job numbers remains relatively strong, at 3.3%pa, and the unemployment rate is at a still-low 3.6%.

One of the outcomes from a tight labour market is upward pressure on wages. We estimate that wage inflation has peaked and will gradually ease from 7.0%pa at the end of 2023 to 4.7%pa by December 2024 and 3.7%pa by December 2025. However, a more important factor in the battle against inflation is the effect of the labour market’s resilience on consumer confidence and willingness to spend. Without a definite softening in labour market outcomes, better sustained job and income security is likely to mean less downward pressure on household spending. As a result, the broader rebalancing of demand and supply in the economy that the Reserve Bank is trying to engineer will become harder to achieve.

At this stage, we still expect the unemployment rate to push up to 4.9% in the second half of 2024. However, in our view, continued employment growth raises considerable demand-led inflation risks. A clear deterioration in labour market indicators is needed to make us comfortable the Reserve Bank has done enough to quell excess demand.

Net migration has surged to a record high of 110,200 over the year to August 2023. But alongside the massive inflows of foreign workers arriving to fill holes in the labour market, Stats NZ has recently been revising up its estimates of the number of Kiwis permanently heading overseas. The revisions mean that current departure trends look much more like the brain drain we had feared would occur in mid-2022 after MIQ had been disestablished.

If arrival numbers continue to ease in coming months as pent-up demand for workers dissipates, the flow of Kiwi departures will become a more dominant theme in the numbers and drag net migration lower. Australia’s unemployment rate remains at a similar level to New Zealand’s rate, and so Australia will continue to be a strong drawcard for Australia given relative incomes, house prices, and other living costs.

Graph 2 shows that we expect net migration to slip below 20,000pa by early 2025, before averaging around 28,100pa during the three years to June 2028. Fewer job opportunities in New Zealand will keep arrival numbers more subdued than they have been over the last year, but we still expect arrivals to be only slightly below their 2015-2018 level. The key difference compared to the second half of last decade will be the sustained higher number of departures.

Graph 2

In the near-term, we note the possible inflationary effects associated with the additional demand being created by new arrivals into the country. These effects are likely to be relatively short-lived given the boost to aggregate supply as the immigrants settle into their new jobs. More critically, any unexpected persistent strength in the labour market would have flow-on effects for immigration and, potentially, the housing market. These demand-side risks pose yet another hazard for the Reserve Bank to consider as it assesses whether it is successfully bringing inflation under control.

Unlike the labour market, the housing market has definitely turned a corner in the last few months. Sales are up, prices have started to edge higher again, and properties are spending less time on the market before selling.

Given that mortgage rates are still edging higher, the housing market’s turnaround has happened sooner than we expected. Migration inflows are the driver of the lift in demand, with people coming into the country needing somewhere to live. Alongside the emerging lift in house prices, rental inflation has also been accelerating.

Nevertheless, we remain sceptical of how far house prices can be bid up, given current mortgage rates. We expect prohibitively high debt-servicing costs to limit how much potential buyers are able to borrow throughout 2024. As a result, we forecast that house prices will only rise by about 5% over the next 18 months (see Graph 3). This prediction is considerably less than the double-digit increases being expected by several other forecasters, which suggests that the near-term risks to our outlook are on the upside.

Graph 3

A relaxation of the tax regulations for property investors by the new government could also add more demand back into the housing market than we have allowed for during 2024.

At its heart, our fundamental view is that housing remains overvalued, and we do not expect property values to surpass their 2021 high within our five-year forecast period. Even if migration does lead to a larger rebound in house prices between during 2024, we would expect the sharp slowdown in population growth by 2025 to see upward momentum in prices dissipate pretty quickly. In our view, any excessive bounce in house prices next year simply creates more scope for another bout of price declines later in the forecast period.

Indicators of household spending have been mixed. Despite a 1.9% decline in retail sales volumes over the year to June, GDP data shows that private consumption has expanded by 3.2% over the same period and has not recorded a quarterly decline since mid-2022.

We continue to expect declines in consumption spending over the second half of this year, taking year-end growth down to a low point of 0.5%pa by September 2024. The continued roll-off of fixed mortgages onto higher rates, along with the expected softening in the labour market, will continue to weigh on spending over the next year. High fuel prices will also squeeze household budgets in the near-term, and cost-of-living pressures will persist into 2024 as increased transport costs push up prices for other goods and services.

Excluding the lockdown-affected results in 2020, this rate of spending growth would be the weakest since 2009. Nevertheless, Graph 4 shows that it still represents an upward revision to our spending outlook published in July, which saw growth turning negative and bottoming out at -0.4%pa. Expected tax cuts by the new government will also help cement a less negative outlook for spending growth during 2024.

Graph 4

We see two upside risks to this outlook. As previously noted, continued resilience in the labour market would also be likely to lead to less negative consumer confidence and better spending outcomes. The resilient labour market would also keep migration numbers higher and therefore boost aggregate spending volumes. Secondly, a stronger housing market performance over the next 18 months could also push up associated spending on durables such as furniture and appliances. There is also the possibility that rising house prices boost people’s willingness to spend more broadly, thanks to the wealth and confidence effects associated with appreciating property values.

We have scaled back our predictions of growth in government consumption spending throughout the forecast period due to the change in government. National, ACT, and NZ First (who are likely to be needed to form a government once special votes are counted) have campaigned on reducing bureaucracy and slimming down government departments, and we expect the effects of this policy goal to become evident in the numbers by mid-2024.

The change of government also raises risks around government investment spending. Although capex spending has displayed stronger-than-expected growth during 2023, we do not predict this momentum to be sustained into 2024. In particular, we expect adjustments to the government’s spending priorities to create something of a hole in investment activity during 2024, with it taking some time to replace cancelled projects with other schemes that the new government is looking to fast-track. We now expect a 6.6% contraction in government investment during 2024, with year-end spending growth possibly not turning positive again until late 2025 (see Graph 5).

Graph 5

After being a star performer for the economy throughout the COVID-19 pandemic, New Zealand’s primary sector is now coming under considerable pressure from falling export prices. ANZ’s commodity price index shows that world prices for meat, dairy, and forestry products are all down by 19-36% from their peaks in 2021 and 2022. The magnitude of these falls on exporters’ revenue has been mitigated by the lower New Zealand dollar, but the price falls over the last 1-2 years are still sizable.

Even for horticulture, where prices reached an all-time high in August, the outlook is mixed. The extreme weather events in early 2023 have meant that production volumes are lower than normal, meaning that many growers are unable to take advantage of the higher prices.

The lower revenue for farmers comes in the wake of a significant increase in costs over the last two years. Although fertiliser prices have moderated since the end of 2022, they are still 42% higher than they were two years ago. Fuel costs have also risen substantially, and farmers are feeling the effects of rising interest rates as much as households.

On the demand front, expectations of Chinese economic growth during 2024 have slipped from 5.2% to 4.5% since March, according to Consensus forecasts. The Chinese economy has come under pressure from weak global demand, which is limiting growth in manufacturing activity. The country’s housing market remains under significant pressure from oversupply and falling house prices, with lending growth weakening despite interest rates being cut. Add rising unemployment into the mix, and it is understandable that Chinese consumer confidence is weak, leading to a pull-back in discretionary spending by households.

Against this sobering backdrop, we are downbeat about prospects for New Zealand’s agricultural-based provincial regions over the next 18 months. Export growth is set to slow from 12%pa in mid-2023 to just 4.8%pa by mid-2024, and the effects on the provinces will be amplified by a slide in the terms of trade to its lowest level since 2019.

Back in May, when the Reserve Bank lifted the OCR to 5.5% and indicated it was on hold, we stated that it would be six months before there would be enough evidence to say whether the Bank had done enough or not. Although several indicators of economic activity remain relatively resilient, the definite easing in headline inflation means there would now need to be a substantial pick-up in demand and pricing momentum for the Reserve Bank to push the OCR any higher.

At the moment, trends in global interest rates are also working in the Reserve Bank’s favour. Rising longer-term rates internationally have pushed 10-year government bond rates in New Zealand to their highest level since 2011. This increase has translated through into ongoing upward pressure on some fixed mortgage rates, particularly the one-year and two-year rates most heavily favoured by borrowers. In essence, financial markets are implementing a de facto tightening for the Reserve Bank, which reduces the need for any increase in the OCR.

Given some of the inflationary risks posed by higher fuel prices, the rebounding housing market, and the resilient domestic economy, we have pushed out the timing of any interest rate cuts. We now expect the OCR to stay at 5.5% until it starts to be reduced at the end of 2024 (see Graph 6). If inflation continues to track lower throughout the next 6-9 months, there is potential for the first rate cut to occur earlier. However, the lower headline inflation rate would need to be accompanied by a clear easing in non-tradable inflation as well.

Graph 6

Our predicted trough in GDP growth of 0.9%pa during 2024/25 represents a soft landing for the economy, and it is a sizable upward revision from the -0.4% we had built into our July forecasts (see Graph 7). Stronger population growth and household spending are key contributors to the result. The likely retention of current monetary settings by the Reserve Bank, despite substantially higher fuel prices, will also help to achieve a shallower slowdown.

Graph 7

Nevertheless, growth conditions will not be easy throughout the next two years, as the economy continues to rebalance in the wake of the stimulus during the COVID-19 pandemic. And there is a risk that, by taking a relaxed stance about the increased inflationary concerns now, the Reserve Bank is forced to tighten monetary policy later in 2024 and constrain the economy further into 2025/26. Holding back on the medicine, only to have to administer it later, would probably be the least palatable outcome of all.

Despite our caution, the Reserve Bank clearly doesn’t have enough evidence of overly persistent inflation to meet the high bar it set itself to recommence interest rates rises. Those conditions might still be met but, if they are, it won’t occur until some stage in 2024. For now, inflationary trends are encouragingly moving in the right direction, but we’re not fully convinced that they will stay that way.