Patchy economic recovery as job losses outweigh interest rate cuts

In many respects, the economy has continued to evolve as we had anticipated over the last few months. Although much of the softness has been expected, high electricity prices have emerged as an additional drag on economic activity, adding to the bad news in the labour market. The other surprise element has been the Reserve Bank’s monetary policy flip-flop, which saw the official cash rate cut 12 months earlier than previously signalled. We’ll examine the effects of that change later in our Forecast Story , but first let’s canvass the areas of weakness that have ultimately contributed to the Bank’s decision to start easing monetary conditions.

It would be wrong to blame all the recent announcements of factory closures on the energy crisis. The manufacturing industry was already under considerable pressure before electricity prices spiked higher. Residential construction volumes have been trending downwards for almost two years, and with those falls gaining momentum since mid-2023, demand for associated manufactured products has declined. Broader domestic demand levels have retreated from their pandemic highs, when people were actively supporting local businesses and buying from within New Zealand to avoid the disruptions and higher costs associated with international shipping. Domestic demand has now returned to normal or below-normal levels, and international demand has also weakened over the last two years as higher interest rates have restricted spending across developed economies.

However, this trend of weaker demand, implying lower revenue, in tandem with higher cost structures over the last three years, has been brought to a head by the recent surge in electricity prices. The profitability of businesses struggling to remain viable has been completely undermined by higher energy prices. The immediate negative effects of high electricity prices on economic activity have dissipated as spot prices have moderated since late August. But the permanent or semi-permanent changes caused by reductions in wood processing, methanol production, and aluminium smelting volumes will have longer-lasting implications for economic growth and the structure of the economy.

We estimate that economic growth in the September 2024 quarter was negative as a direct result of the energy crisis. However, we have also tapered our expected recovery in economic growth through until mid-2025 (see Graph 1). This shift is a direct reflection of the structural changes being accelerated by the combination of weak demand and high costs faced by manufacturing businesses.

Graph 1

The news is little better across many of parts of the economy. Below we have catalogued several key areas of weakness, although this list is not intended to be an exhaustive one.

Agriculture continues to come under considerable pressure from a combination of high costs and lower sales prices. Conditions are less critical than they were 12 months ago, with ANZ’s commodity price indices showing a 17% rebound in dairy prices since August 2023 and a 24% lift in meat prices (mostly beef, rather than lamb) since December last year. On-farm costs have risen just 0.1% since September 2023, and they could trend a bit lower as interest rate cuts reduce debt-servicing costs. However, costs are still 25% higher than they were at the end of 2020.

Against this backdrop, farmers’ profitability looks likely to be better in 2025, but it is still hard to make the economics of sheep and beef farming stack up against planting trees (as a carbon sink, rather than for the wood itself). The ongoing pressure to convert farmland to forestry has more longstanding and structural implications for provincial economies and their workforces.

Although the recovery in international visitor numbers is boosting economic growth in areas such as Queenstown, it would be wrong to conclude that conditions in the tourism sector are rosy. International arrivals currently seem to be holding at about 85-90% of pre-COVID (2019) levels, while the squeeze on household budgets has seen the annual total of domestic guest nights decline 5.8% since May 2023. We expect the international segment to continue grinding out a gradual recovery over coming quarters, but hospitality and tourism operators are likely to be operating with significant levels of spare capacity for some time yet.

Partly related to these issues, the retail and hospitality industries are hurting badly from spending caution by cash-strapped households, probably to a greater degree than some of the official numbers suggest. The effects are not being felt evenly, with parts of the North Island and CBDs in the major urban areas seeming to be most critically affected. As across many other parts of the economy, significantly higher operating costs have exacerbated the effects of weak demand on profitability. Lower interest rates provide a small glimmer of light at the end of the tunnel, but further job losses and business closures are likely before demand stabilises and spending starts to trend higher again.

Surveys suggest that sentiment in the construction industry is less downbeat than it has been all year. However, any expectations of a stabilisation in residential activity before mid-2025 would seem to be premature given that the full effects of declines in consent numbers since mid-2022 have yet to be seen in work put in place figures. Further job cuts and funding constraints at Kāinga Ora do not augur well for the social housing construction programme. Likely falls in public sector activity come on top of the downward pressure on private sector work, where it is difficult to make new developments stack up given the combination of flat or falling house prices, much higher building costs, and a lack of buyer demand.

Non-residential consent volumes have also been shrinking since mid-2023, pointing towards a looming downturn in activity. Private sector activity is being inhibited by high interest rates, low rental yields, and high building and operating costs. Although there has recently been some improvement in broader investment intentions, we do not see this shift translating into a pick-up in non-residential work any time soon. Tight fiscal conditions are also weighing heavily on the prospects for education and hospital building, and major questions remain over the government’s ability to fund and progress its infrastructure plans.

Alongside the recent pick-up in investment intentions, measures of business confidence and own-activity expectations have also improved significantly over the last couple of months. Given the broad range of industries that are currently struggling, we question how much substance there is to the rebound in confidence. Is it more of a suggestion from businesses that things surely can’t get any worse from here so, by extension, conditions must be better in 12 months’ time?

Recent data suggests the labour market is slowing more sharply than we had anticipated earlier in the year. Annual jobs growth from tax-based monthly employment indicators has turned negative as businesses have responded to the raft of pressures outlined above. In addition to the industries already mentioned, the professional services industry is being hit by government spending cuts, reduced business-to-business activity as firms look to cut their costs, as well as flow-on effects from the construction downturn for the likes of architects and engineers.

Public sector employment has been held up, to date, by continued growth in healthcare and education job numbers. The highly publicised redundancies and restructuring throughout central government have yet to show through in the numbers, but we expect these cuts to become more apparent before the end of this year.

We expect 2024 to finish with no employment growth, and for patchy growth in job numbers of just 1.1% during 2025 (see Graph 2). These results will drive the unemployment rate up to a peak of 5.4% in mid-2025, which is slightly higher than we had previously forecast. Given the current reluctance among firms to take on staff, and the fact that job losses are becoming more widespread than expected, the risks are for even weaker employment results and a higher peak unemployment rate. Some of the labour market weakness is also being masked by Australia’s relatively better economic conditions, which are enticing people across the Tasman and absorbing some of New Zealand’s spare labour capacity.

Graph 2

The evaporation of employees’ bargaining power is likely to lead to a faster moderation in wage inflation during 2025. Although this outcome is a positive for businesses that are trying to rein in costs, it points towards slower real income growth for households. Effectively, workers are less likely to be fully compensated for the price increases of the last 2-3 years through higher wages, implying some reduction in their real wages.

Employment growth is set to recover further towards 2%pa during 2026 as broader demand conditions improve across the economy and businesses become more comfortable hiring again. We continue to expect the unemployment rate to hold around 4.5% over the medium term.

Following the Reserve Bank’s surprise interest rate cut in August, followed by a 50-point cut in October, we now expect another 50-point cut to the official cash rate (OCR) before Christmas. Further 25-point cuts during the first half of next year would take the OCR to 3.5% by mid-2025.

Graph 3

A high degree of uncertainty remains around future monetary policy decisions. Reasons for this uncertainty include the Reserve Bank’s seeming inability to look forward when setting monetary policy, its recent change of focus to “high-frequency indicators”, and inconsistency in communication.

Whatever the case, the downward direction of travel for the OCR is appropriate, and it is somewhat reassuring that the Reserve Bank has realised the economy is struggling, inflation is under control, and monetary conditions need to be less restrictive. However, other negative factors in the last few months (such as the energy crisis) have outweighed the positive effects of the earlier interest rate cuts on the near-term outlook for the economy.

With both actual inflation and inflation expectations having returned towards the midpoint of the Reserve Bank’s 1-3%pa target band faster than might have been expected 12-18 months ago, the neutral OCR could be lower than we had previously assessed. This possibility creates downside risks to our OCR forecasts in late 2025 and early 2026, particularly with economic growth set to remain patchy throughout 2025. By the middle of next year, the Reserve Bank could find it needs to cut the OCR further to help provide the economic recovery with more momentum.

Interest rate cuts will help improve housing affordability, by reducing debt-servicing costs, throughout the next year. However, house prices relative to incomes (either owner-occupier incomes or rental incomes for landlords) are still high by historical standards. We have revised up our expectations for house price growth to 5%pa in 2025, but we continue to take a cautious view about prospects for house price growth over the medium-term.

Although business confidence has improved significantly over the last few months, consumer confidence remains relatively weak. Expectations around the labour market will be a key determinant of consumer confidence and household spending throughout the next 9-12 months, with people likely to stay restrained in their spending patterns while job security remains weak. We expect this labour market influence to dominate the effects of the improvement in households’ disposable incomes over coming months as mortgage rates decline and people start rolling onto lower rates.

At the same time, businesses are reluctant to hire or invest without some signs that improving demand conditions are on their way. In this respect, the economy’s forecast recovery during 2025/26 has a self-reinforcing element to it. The recovery will remain patchy and struggle to gain momentum until trends in confidence, spending, and employment are all heading in the right direction.

Further sapping the economy’s momentum is the rapid reversal in net migration over the last year. Annual net migration peaked at 136,380 in the year to October 2023, but it has since retreated swiftly to 53,844 by August this year. With arrivals drying up quickly, we now expect the net inflow to be below 38,000pa by the end of 2024. Not only are fewer migrants entering the country; there is also evidence that some relatively recent arrivals are leaving again, because they or their partners are unable to find work due to the softer labour market.

We expect annual net migration to turn negative in 2026/27. Population growth of just 0.2%pa in the March 2027 year would be the slowest since about 1986 (excluding during 2022 when the borders were shut). This outlook reflects reduced arrival numbers, as well as more Kiwi departures than we had previously allowed for due to New Zealand’s labour market underperformance. Australia’s unemployment rate is currently half a percentage point below New Zealand’s. This gap is expected to widen further during the next year and remain in Australia’s favour until mid-2027.

Graph 4

Slower population growth will reduce the New Zealand economy’s potential growth rate throughout the forecast period. This shift has been a major contributing factor to a downward revision to our forecast for economic growth between mid-2026 and mid-2028 from an average of 2.8%pa to 2.1%pa.

Interest rate cuts are welcome relief for a struggling economy, but they will not immediately boost activity, and other factors will need to come together before the recovery is embedded. We expect better growth outcomes to become apparent by the second half of 2025 as easier monetary conditions and some improvement in export revenues stimulate more spending activity. That upturn could be amplified if the Reserve Bank decides it kept interest rates high for too long and subsequently cuts rates further and faster to combat disinflation. However, some of the structural issues being faced by the New Zealand economy leave lingering questions about medium-term potential growth.