Reserve Bank’s overly tight approach stunts already difficult recovery

Weak demand across the economy is feeding through into business caution around investment and hiring, and the softer labour market is further hitting consumer confidence. A rise in the unemployment rate to 5.3% in mid-2025 will continue to limit consumer spending through into 2025/26, with any improvement only likely to occur when households have clear evidence that the Reserve Bank is easing monetary policy. Despite weak demand conditions reducing price pressures and rapidly bringing inflation back within the 1-3% target band, some messaging from the Reserve Bank remains overly cautious. In our view, the official cash rate should be cut before the end of 2024, but we currently expect the Bank to delay the start of interest rate cuts until February next year.

Although there are some signs of improvement in the global economy and commodity prices, prospects for exporters remain patchy due to China’s economic struggles, ongoing conflict, and risks around more protectionist trade policies. Domestically, fiscal policy will need to stay tight for longer to get the government accounts back into surplus. All these factors point to a slower recovery in economic growth during 2025 and 2026 than we had previously hoped for, with year-end GDP growth reaching just 1.5% at the end of next year and 2.5% by the end of 2026.

After a rally in confidence in the latter part of 2023, both businesses and consumers have become more pessimistic throughout 2024. The NZIER’s latest Quarterly Survey of Business Opinion shows that firms’ experience of domestic trading activity is at its lowest since 2008/09 (excluding the 2020 lockdown). This result lines up with the messages about a significant weakening in demand that we have been getting from businesses in recent months. Consumers are retreating further into their shells as the financial pressures of high interest rates are compounded by increasing concerns about the deteriorating labour market. Business-to-business activity is also being hit by reduced profitability, leading to cost-cutting measures and a reluctance to invest.

Household concerns about the labour market are demonstrated by the fall in Westpac McDermott Miller’s employment confidence to its lowest level on record (excluding lockdown, with data back to 2004). The Quarterly Survey of Business Opinion’s reading on employment levels by firms over the last three months was the worst since the Global Financial Crisis, suggesting households’ fears are well-founded. Job ad numbers have plunged 22% since the end of last year and now sit 29% below their 2019 pre-pandemic level (seasonally adjusted), demonstrating the reduction in appetite for hiring.

We continue to forecast a lift in the unemployment rate from 4.3% currently to 5.0% in the second half of this year, with a peak rate of 5.3% during 2025. Previously, we’ve seen this increase in unemployment being caused by strong population growth running ahead of employment growth. Our central forecast is still for this outcome, with year-end employment growth bottoming out at 0.3%pa in early 2025 (see Graph 1) – that’s still growth, just much slower growth.

Graph 1

However, the broad deterioration in labour market indicators indicates that we could be on the verge of aggregate job losses and employment declines, presenting downside risks to our employment forecast and chances of a higher peak unemployment rate.

In our view, this marked shift in labour market indicators confirms expectations of a slowdown in wage growth throughout the next 1-2 years. We forecast that growth in the labour cost index will have eased from 4.1%pa currently to below 3.0%pa by mid-2025 and below 2.5%pa by early 2026. This gradual moderation reflects a period of lingering catch-up in wages for staff in the near-term to reflect the cost-of-living increases over the last couple of years. But as with employment, the risks to this forecast lie to the downside, as the bargaining power of workers is diminished by the increasing slack in the labour market.

Weaker wage growth is one of the key shifts the Reserve Bank is looking for in its battle to get inflation back under control. The Bank’s focus on the labour market has intensified recently, with poor productivity data raising concerns that high wage growth is simply adding to the cost base of businesses, rather than being justified by higher output per worker. Any increases in costs might simply be passed on to customers, leading to lingering inflation throughout the domestic economy.

That concern has been backed up by non-tradable inflation only easing from 6.8% to 5.4%pa since March last year, while headline inflation has slowed from 6.7% to 3.3%pa over the same period. Add in substantial price rises for insurance, electricity, and local government rates, and its easy to see why the Reserve Bank might be concerned about sticky domestic inflation.

However, we are increasingly coming to the view that inflation is mostly beaten. The specific inflationary concerns outlined above are outweighed by weak demand conditions, which are forcing businesses to absorb more cost increases and keep pricing in check. Competitive pressures and the fear of losing market share are resulting in inflation moderating rapidly. Graph 2 shows that we expect inflation to be down at 2.5%pa by the end of this year, drifting further down towards 2.0%pa by early 2026.

Graph 2

In short, we’re getting more of the evidence we wanted to reassure us that inflation is being wrestled under control, but we still think the Reserve Bank will take an overly cautious approach to interest rate setting. Despite the deterioration in economic activity, and market sentiment becoming significantly more relaxed about prospects for inflation, some of the Reserve Bank’s messaging has shown a hawkish monetary policy stance. The Bank’s most recent forecasts, published in May, pointed to the official cash rate (OCR) being held at 5.5% until the September 2025 quarter, with the Bank even actively discussing a further increase in the OCR.

Following the Bank’s May statement, we pushed out the timing of our first expected OCR cut from November this year to February 2025. That view was borne out of what we expect the Reserve Bank will do, not necessarily what we think should happen. We are increasingly of the view that the Reserve Bank is not being forward-looking enough in setting monetary policy, and that it is waiting too long to cut interest rates. The Bank’s forecast that the OCR remains on hold until September next year looks simply outlandish, and even keeping the OCR at 5.5% until February next year could be too long given the deteriorating economic outlook.

With around 90% of mortgage lending on fixed rates, any interest rate cuts will take several quarters to have a significant effect on household budgets. The Bank’s seeming inability to look forward properly when setting monetary policy is reminiscent of its slow reactions to accelerating inflation in 2021/22, when it insisted that inflation was “transitory” and that a more rapid tightening was not necessary. We increasingly see enough evidence to cut the OCR in November this year, but we just don’t see how the Bank could move so quickly given its previous stance – hence our February 2025 pick.

The effects of this leaden footedness show through across our outlook for several key indicators of economic activity. Our forecasts of growth in business investment and GDP recover more slowly over the next 18 months than the projections we had published in April. Household spending suffers a similar fate of a more subdued recovery, despite year-end growth holding up better in the near term due to some dubiously strong numbers in the March 2024 quarter.

Once the Reserve Bank does start to reduce interest rates, we expect a steady, but not rapid, pace of cuts to take the OCR to 4% by the end of next year (see Graph 3). With inflation close to 2% and fiscal policy likely to remain relatively tight throughout the forecast period, we see scope for the OCR to get down to 3.5% in 2026, providing a modest amount of stimulation to the economy.

Graph 3

Although market expectations of interest rate cuts by other central banks this year have also had to be pared back, the Reserve Bank’s hawkish stance presents upside risks to our exchange rate forecasts. As other central banks begin to cut rates, New Zealand’s interest rates will become more attractive to foreign investors and potentially lead to an increased flow of funds coming into the country.

One part of the economy where we have lifted our near-term forecasts is government consumption spending. This shift reflects fiscal policy that is not quite as tight as we had previously anticipated. But with growth in spending holding between -0.1% and %pa throughout the next year, the numbers cannot be interpreted as the government coming to the economy’s rescue to pull it out of the doldrums.

With higher debt levels and slightly less of a clampdown in spending taking place in the near term, we think the government’s push for cost savings will continue through into next year’s budget at least. The Treasury noted in this year’s budget that “future budget allowances [of an additional $2.4b per annum] are unlikely to be sufficient to cover future cost pressures on existing services” caused by factors such as inflation or population growth. As a result, we expect the government to pursue further cost savings over the coming year to help it stay within these operating allowances as well as provide some room for other new policy initiatives. The downward revisions to our forecasts of government consumption between mid-2025 and mid-2027, shown in Graph 4, reflect these fiscal constraints.

Graph 4

At the same time, the provision of more funds for infrastructure work has led to a stronger outlook for government investment from 2026 onwards. Growth of up to 5%pa follows an expected hole in activity over the next 12 months as planning and design work is progressed for major new projects, and other work streams (such as school and state house building) are scaled back. However, ongoing rebuilding work following last year’s floods and cyclones presents an upside risk to this forecast.

New Zealand’s exporters continue to grapple with the effects of a weak global economy, although there have been a few snippets of good news in recent months. The tourism sector recovery continues to grind away, with visitor arrivals in the first four months of this year back up to 83% of 2019 pre-pandemic levels. ANZ’s commodity price index also shows a 12% rebound in international commodity prices since August 2023, led by a 20% lift in dairy prices and a 13% rise in meat prices (the latter since January this year, and off a low base).

Even so, the bounce in export prices follows a 31% decline in the overall index between March 2022 and August last year. This slump in revenue came alongside a 25% surge in average farm input costs over the three years to June 2023, implying a hefty hit to profits that producers will not yet have recovered from.

From New Zealand’s perspective, the global economic outlook continues to be dominated by the struggling Chinese economy. Chinese growth is expected to be 5.0% during 2024, with the weak housing market, a soft labour market, and low consumer confidence all weighing on spending. Even with a range of government support measures for the housing market, Chinese economic growth is forecast to slip below 4.5%pa in 2025 and continue to ease in subsequent years, as China’s shrinking population, push towards greater self-sufficiency in some areas of production, and increasing attention to environmental outcomes all result in slower growth.

Economic growth in Europe is set to pick up throughout the next 12 months as demand conditions stabilise, inflation moderates, and interest rates are gradually cut. However, Europe’s recovery will be constrained by relatively high energy prices resulting from ongoing conflict in Ukraine and the Middle East, as well as disruption to trade through the Red Sea caused by the latter.

Although the US appears to be on course for a soft landing, there are concerns about prospects for New Zealand exports if Donald Trump is re-elected as president. His plan to impose a universal 10% tariff on all products entering the US threatens to undermine the growth in New Zealand exports to the US that has been achieved over recent years.

Against this backdrop, the government’s efforts around free-trade agreements (FTA) with India and the United Arab Emirates are vital for shoring up New Zealand’s medium-term export prospects. Australia’s FTA with India, which came into force at the end of 2022, demonstrates the potential for a greater trading relationship – even though New Zealand would almost certainly be forced to exclude dairy products from any FTA.

Although we estimate that year-end economic growth bottomed out in the June 2024 quarter at -0.3%pa, growth is set to remain patchy until mid-2025 as tight fiscal policy and overly restrictive monetary policy weigh on activity.

We expect the catalyst for recovery in 12 months’ time will be actual evidence for households of declining interest rates, along with signs that the labour market has bottomed out. These factors should be sufficient to drive an improvement in consumer confidence and better growth in spending (particularly on a per-capita basis). Improving profitability across the agricultural and tourism sectors will also filter through into a pick-up in economic activity.

By the end of 2025, we forecast economic growth to be at a 2½-year high of 1.5%pa, accelerating to 2.5%pa by the end of 2026 as less restrictive monetary conditions have their full effect (see Graph 5). The acceleration during 2026 will be aided by additional government investment, as the government aims to boost economic growth ahead of that year’s election.

Graph 5

Economic growth of up to 3.0%pa remains possible later in the forecast period. However, New Zealand will need a favourable global economic and trading environment, along with an improved productivity performance compared with recent history, to achieve sustained growth of that rate.