A better mix of inflation and growth for NZ

A clear trend of easing inflation is allied with prospects of more positive economic growth outcomes for New Zealand during 2024/25. Inflation is set to slip below 3%pa in the second half of this year, providing scope for the Reserve Bank to start cutting the official cash rate from August. Lower interest rates will foster more positive trends in private sector investment, and business trading conditions will also be bolstered by strong population growth, as net migration subsides more slowly than we had previously expected.

However, it’s not all good news on the economic front. China’s economic struggles will continue to weigh on the export sector and, by extension, New Zealand’s agriculturally based regions throughout the next 18 months. Several upside cost risks, both domestically and internationally, still have the potential to prevent inflation from continuing its path of moderation as smoothly as might be hoped.

So inflation is back under control? That’s what international financial markets would have you believe, at least, with swap rates plunging by 70-130 basis points between October and late December last year. Swap rates, which are used by banks for funding and pricing their retail fixed mortgage rates, have got down to their lowest levels since late 2022 or early 2023. And with consumer price inflation back below 5%pa for the first time since 2021, financial markets might be right.

Several factors have contributed to the more sanguine view of financial markets towards the inflation outlook.

• Headline inflation in the US has held at 3.3%pa or below since October last year, and core inflation (excluding food and energy) has continued to moderate.
• The weak global economy has seen tradable inflation fall away. Lower prices for exporters also have negative implications for demand conditions and economic growth in New Zealand over the next 18 months.
• The rising unemployment rate in New Zealand has convinced markets that growth in labour costs, which could have underpinned more persistent inflationary pressures, will continue easing.

Last week’s December quarter inflation result also saw headline inflation slip below 5%pa for the first time in more than two years, confirming that New Zealand’s inflation is heading in the right direction.

Against this backdrop, we have pulled down our inflation forecasts. We now expect inflation to be back inside the Reserve Bank’s 1-3%pa target band by September this year (see Graph 1).

Graph 1

If inflation is going to be back in the Reserve Bank’s target band in the second half of this year, the outlook for the official cash rate suddenly becomes clearer. Given that changes in monetary settings typically work with a lag of 9-18 months, there is little need for the Bank to raise the official cash rate (OCR) above its current level of 5.5%. In fact, the faster return of inflation towards its target should provide scope for the Bank to cut the OCR from August this year, which is three months earlier than we had previously been expecting.

However, as Graph 2 shows, this change in our forecasts is perhaps more about style than substance. We still expect the OCR to track to around 4% by the end of 2025 and 3% by the end of the forecast period. But the accompanying shift in our expectations for economic growth is arguably what makes the interest rate profile that much more remarkable.

Graph 2

We are forecasting economic growth to remain weaker than previously predicted through until mid-2024. But the most significant change in our GDP forecasts is our expectation that growth will pop back up to around 2%pa by the end of this year (see Graph 3). There are a few dynamics at play behind this shift.

Graph 3

Revisions to GDP data at the end of last year included significantly weaker starting points for investment spending across most parts of the economy – particularly government investment, but also residential and non-residential construction, as well as private sector non-building investment. To some degree, this weakness has been exacerbated by continued upward pressure on retail interest rates throughout the mid-to-latter part of 2023. However, it also creates scope for a more positive (or less negative) performance across these components of GDP later in 2024 and 2025, if conditions are right.

Those “right” conditions are likely to be facilitated by two factors: declining interest rates and continued strong population growth. We have outlined our thinking above about the outlook for interest rates. Population growth has been at a 70-year high thanks to exceptionally strong net migration, and although our expectation is for it to ease during 2024, this moderation is likely to occur more slowly than we had previously thought (see Graph 4). More buoyant demand conditions for businesses will encourage more investment, later this year and into 2025, while the downturn in construction activity will be less marked because the larger population needs to be housed and serviced. These additional people in the country are also boosting aggregate household spending although, in the near term, this positive effect on economic growth is outweighed by downward revisions to other components of GDP.

Graph 4

One of those near-term downward revisions has been to export growth. Although optimism around growth prospects for the US economy has increased as inflation has moderated, the same can’t be said for China, New Zealand’s largest export market. China’s weak domestic economy, in particular, has weighed on commodity prices for most of New Zealand’s agricultural exports, placing downward pressure on revenue and prospects for provincial growth.

Perhaps most instructive of China’s effect on New Zealand is the decline in its share of our total exports from 32% to 27% over the last two years. The first figure might have been amplified by Covid’s effects on international trade flows, but the last time we saw a drop of this magnitude was in 2014/15. That period was an incredibly difficult one for farmers, as China temporarily cut back its demand for dairy products. We anticipate a similar phase of weak revenue and low profitability for farmers throughout 2024, with sluggish export volumes contributing to poor economic growth across most provinces reliant on agricultural exports.

We expect weaker near-term growth in exports to be counterbalanced by a slightly better growth performance during 2025 (see Graph 5). A mixture of Chinese government stimulus during 2023/24 and stronger international demand conditions later this year are likely to flow through into a better mix of Chinese economic growth in 2025 – even if official GDP growth for China remains in the 4-5%pa range. We now expect export volumes to expand by 4.1% during 2025 which, in tandem to our downward revision for export growth in 2024, means that total growth over the next two years remains almost identical to our previous forecast.

Graph 5

The switch over the last six months away from our previous status as inflation hawks has been a sharp one. Easing headline inflation, a moderation in global price pressures, and the development of some slack in the labour market have made a compelling case that inflation is under control. But with headline inflation still up at 4.7%pa, there are lingering risks that could still see the remaining vestiges of inflation prove to be more difficult to eliminate.

Arguably the most significant of these risks is presented by migration, which is yet to definitively peak. We have revised up our net migration forecast by 53,300 people for 2024, and at the moment there is seemingly no guarantee that we won’t have to revise it up further.

Although the migration influx is creating more slack in the labour market, it is also adding to demand across parts of the economy, including in the retail sector, the housing market, and on infrastructure networks.

Given the pressure the retail sector has been under as household spending has been hit by higher interest rates and other cost-of-living pressures, it probably has the most capacity to deal with increased demand without any material effect on pricing behaviour. However, it is difficult to be as confident about the housing market or infrastructure sectors. Although residential construction activity has started to retreat from its peak, the industry has been severely stretched over the last few years, making it easy to envisage a renewed pick-up in construction cost pressures if demand for new building is rekindled by rapid population growth. We have also already seen faster rental inflation as population growth has picked up, and stronger house sales activity and prices could flow through into more consumer spending activity as well, further adding to broader demand pressures.

Furthermore, the pre-existing constraints around infrastructure funding and delivery are well documented – New Zealand is having enough trouble meeting the infrastructure needs of its existing population, let alone adding a lot of extra new demand into the mix. We see risks that cost pressures in this area remain problematic.

Looking at offshore factors, the risks posed by high international oil prices seem to have dissipated, despite the ongoing conflict in Gaza. We have lowered our forecasts of retail petrol and diesel prices in New Zealand, although prices will remain elevated by historical standards.

However, the Middle East continues to pose inflationary problems for the globe, with Houthi attacks in the Red Sea disrupting shipping through the Suez Canal and pushing up international freight costs. At this stage, the spike in shipping costs is still modest compared to the one that occurred during 2021 due to the Covid pandemic. We will continue to keep a close eye on developments in transport and freight costs over the next few months.

Finally, it’s worthwhile noting that non-tradable inflation is so far proving to be stickier and more difficult to bring down than tradable inflation. This outcome is hardly a surprise – tradable inflation has averaged 1.4%pa over the last 20 years, while non-tradable inflation has averaged 3.5%pa. In other words, most of our inflationary problems have been of our own making, with domestic price increases mitigated by the effects of globalisation and China’s technological advancement in keeping a lid on international price pressures.

Nevertheless, a failure of non-tradable inflation to moderate further from its current rate of 5.9%pa could indicate that pricing pressure is not dissipating as much or as quickly as the headline inflation number might suggest.

The combination of economic growth over 2%pa and inflation below 3%pa at the end of 2024 very much looks like a soft landing, compared to forecasts from 6-12 months ago. However, it’s important to reiterate that much of this likely success story is a result of very high net migration, meaning that per-capita growth outcomes are negative throughout 2023 and 2024.

As noted above, the demand implications around housing and infrastructure remain key concerns for us, given pre-existing problems with housing affordability and infrastructure delivery. Although the labour market imbalances are being resolved by strong net migration, other imbalances look set to remain problematic.