Desperately wanting the economy’s accelerator to work

The economy’s performance during 2025 has been underwhelming – to say the least – pushing the Reserve Bank towards additional interest rate cuts and raising pressure on the government to support a recovery via infrastructure spending. We see these factors, along with strong export returns and a turnaround in the labour market, driving economic growth up to 2.3%pa by early 2027 (see Chart 1).

Chart 1

Source: Stats NZ, Infometrics

Near-term downside risks continue to be posed by the sluggish global economy and uncertain international trade conditions, alongside weak net migration and the stagnant housing market. But as officials try to drive more activity, we see a chance that they overdo the stimulus, leading to faster GDP growth by late next year, but an accompanying need for interest rates to be ramped up again during 2027. Our forecasts for the next two years are for moderate growth and contained inflation, but the upside risks, whereby both indicators accelerate uncomfortably, are starting to rise.

A 0.9% contraction in the June quarter for the New Zealand economy was not what the doctor (or the government) ordered. The weak outcome appears to have been largely a result of a freeze on activity due to the “Liberation Day” tariffs announced in early April, as well as some noise caused by Stats NZ’s seasonal adjustment process. Although the immediate effects of the international uncertainty on New Zealand’s GDP were larger than we had expected, the result at least partly vindicates the downward revisions we quickly incorporated into our April economic forecasts.

The weak result was at odds with continued strength in business confidence and limited effects on consumer confidence. But the buoyancy of confidence indicators throughout the last 15 months has been perplexing, particularly in business surveys, given the patchy economic outcomes in the wake of last year’s recession. In short, expectations have continued to ride high, even as actual activity has disappointed. Yet businesses still continue to report expectations of improvement going forward!

Prior to the June quarter, the lift in investment intentions was being followed by an improvement in investment spending by businesses, helping provide some momentum to the economy’s turnaround. But arguably the more critical contributor to any recovery would be a pick-up in employment. At this stage, there has been no sustained improvement in either advertising levels or job numbers, leaving employment confidence languishing close to record lows.

The sluggish labour market is not the only thing weighing on consumers’ minds. Pockets of price pressures across essential purchases such as electricity and gas, food, local government rates, and insurance continue to strain budgets and cause angst about the cost of living. These worries mean that, even as mortgage rates come down, people’s first response is to keep making higher mortgage repayments or build up their cash reserves, rather than rushing back to the shops and lifting their discretionary spending.

We continue to expect New Zealand’s economic recovery throughout the next year to be led by the provinces, with the terms of trade at a record high in the June 2025 quarter thanks to strong export prices. However, some recent export-related data means a little caution should be applied to the positive outlook.

Export meat slaughtering volumes fell 9.0% over the year to May, hitting their lowest level since 2017. They have stabilised over the last couple of months, but the decline in slaughtering is being mirrored by falls in meat exports. Although meat export prices have continued to strengthen recently, reduced volumes mean that the pay-off for farmers overall will not be as good as it otherwise could be. A combination of weaker meat volumes, higher-than-expected tariffs for NZ exports to the US, and challenging global growth conditions has contributed to our weaker forecast for New Zealand’s export volumes over the next 6-12 months.

Meanwhile, world prices for our dairy exports have dipped 11% since May, and there has been a 7.6% fall in horticulture export prices over the same period. In real terms, prices for both export commodities are still 15-25% above their average for the last decade, and with strong production volumes, returns to farmers remain healthy. However, the recent softening in prices raises questions about how sustained this period of strong revenue might be. As anticipated, farmers have proven to be relatively cautious so far this year, in terms of increasing their spending in response to improved profitability. Concerns around trends in commodity prices could see that caution persist a little longer than might otherwise have been expected.

Even so, something of a rural-urban divide is showing through in the economic indicators, with South Island areas outperforming the North Island, and weakness in Auckland and Wellington weighing down the overall New Zealand figures. Auckland has been dragged down by weaker construction activity across both the residential and non-residential sectors, a greater sensitivity to last year’s elevated mortgage rates due to high house prices, and significantly weaker net migration slowing the region’s population growth and base for economic growth.

Against this backdrop, the Reserve Bank has cut the official cash rate to 2.5%, and we expect a further reduction to 2.25% before the end of this year. The Bank’s rationale for the larger easing in monetary conditions than had previously been expected is twofold: there is more spare capacity in the economy than anticipated, and the parts of the economy that might be expected to pick up thanks to lower interest rates, such as housing or construction, have been less responsive than hoped.

We have two objections to this assessment. Firstly, we would argue relying on a housing-led economic recovery is difficult given the continued softening in net migration, and imprudent given that house-price-to-income ratios remain worse than at any time prior to 2020. The Reserve Bank has toned down its house price expectations compared with previous forecasts, but it is still expecting house prices to increase by an average of 4.2%pa over the next three years – well above our prediction of -0.4%pa average growth. Both current Prime Minister Christopher Luxon and previous Prime Minister John Key have bought into this flawed logic that the only way the New Zealand economy’s performance can improve is in tandem with rising house prices. We think the economy is better than that – or at least needs to be. We would argue strongly that a slower resumption in faster economic growth is much more favourable than sparking up the economy through excessive house price gains that run ahead of household incomes.

Secondly, we also believe contrasting current economic activity with the levels prevailing in 2021 and 2022 is something of a false comparison, given how overheated the New Zealand economy became during those years. The prolonged run of weak economic indicators reflects a necessary recalibration of activity back to more sustainable levels than when fiscal and monetary settings were excessively stimulatory.

We have been advocating for a degree of patience in allowing the previous monetary easings to have their full effect on economic activity. It takes a considerable period for cuts to the official cash rate (OCR) to flow through into household budgets and spending. The average mortgage rate currently being paid by households is still higher than it was in mid-2023. It will be almost the end of 2026 before the effects of OCR cuts occurring now be fully enjoyed by households. Put another way, the Reserve Bank’s actions today won’t add a lot to the economy’s momentum in the next three months, but they will still be adding additional stimulus to the economy in October 2026. Whether the economy will still need stimulating at that point in time is questionable.

Our forecasts see year-end economic growth accelerating to 2.3%pa by early 2027, and holding at that rate throughout the following 12 months. With weak population growth, per capita growth will be almost 2%pa – comfortably above the 1.4%pa averaged during the 2010s. We have made upward revisions to our near-term forecasts of household spending, with a stronger outlook for business investment and residential construction in 2027. However, by pushing the OCR clearly below neutral, there is a mounting risk that these late-cycle interest rate cuts lead to overly strong growth, particularly kick-starting consumer spending and the housing market, and forcing the Reserve Bank to embark on a new round of tightening by late 2026.

At this stage, we predict the OCR will lift from 2.25% to 3% between November 2026 and April 2027 as the Reserve Bank takes its foot off the gas. But more momentum in economic growth would be likely to lead to further interest rate rises, meaning it is possible the OCR could go as high as 4% by the end of 2027 (see Chart 2). That outcome would effectively continue the Reserve Bank’s recent record of being procyclical and amplifying the economic cycle. The additional pressure on consumer confidence and household spending from another sizable upswing in interest rates could again undermine growth prospects heading into 2028.

Chart 2

Source: RBNZ, Infometrics

One challenge we are grappling with is how the effects of the various OCR cuts since August last year will play out, given lags in interest rates and variability in the economy’s reaction to monetary policy easing. Cutting the OCR further now, to respond to the negative output gap and stimulate more activity, won’t do anything before the end of 2025, given the lags of interest rate effects generally take 9-12 months. Instead, that stimulus might only be hitting the economy as things are already recovering, with the OCR cuts between August 2024 and mid-2025 taking full effect in the first half of 2026.

One argument for OCR cuts now, taking interest rates to clearly stimulatory levels, is that something is needed to kickstart the economic motor and unlock confidence that turns into action (and spending). But if that’s the case – and we accept it might be – then presumably once the kick-start has got things going, we’ll need to bring interest rates back towards neutral? Otherwise, leaving interest rates at too stimulatory levels could see a similar outcome as during the pandemic – economic support for too long, which overstimulates activity and raises pricing pressures. And with headline inflation already at the top of the 1-3%pa target band, there is little room for the Reserve Bank to manoeuvre.

The Reserve Bank finds itself in a difficult position – the economy clearly isn’t turning around as quickly as expected, and so there’s a reasonable call for further stimulus. We forecast based on what we anticipate the Reserve Bank will do, not necessarily what we think they should do. Yet it seems like a stetch to argue that current interest rates have been holding households back, after 250 basis points of OCR cuts, but another 75 basis points will jolt the economy into action. That’s where our concern stems from – we can see the case for more stimulus now, but it makes us increasingly concerned that the Bank will overcook the stimulus, leading to further pricing pressure and/or a quick pivot in interest rates in 12-18 months’ time.

One of the factors adding to the sense of responsibility the Reserve Bank might feel for stimulating the economy is continuing tight fiscal policy. Government consumption grew just 0.6% over the year to June, while government investment contracted 2.6% over the same period. The government remains committed to limiting growth in operating spending, as it looks to return the budget into surplus territory by the end of this decade. However, there have been signs of some movement in the capex space over the last six months, with:

• funding confirmations for school and hospital building work in May’s budget
• July’s confirmation of $6b of social and civil infrastructure work due to start before the end of the year
• accelerated and additional funding for “tradies working in every school this summer” doing repair or construction work.

Although there was nothing new in the July announcement, it highlights the government's push to be delivering on promised work ahead of the next election, which is likely to be in late 2026. With the economy’s patchy performance and weak support in political polls, the government is experiencing increasing pressure for better growth to show through by early next year. Infrastructure spending looks like the channel through which the government thinks it is most likely to achieve that aim. Chart 3 shows our forecasts for accelerating growth in government investment throughout 2026, but the push for more activity points towards additional upside risks to our forecasts for this variable, along with infrastructure activity and economic growth, by late 2026 and through into 2027.

Chart 3

Source: Stats NZ, Infometrics

There are enough near-term risks or headwinds to make it difficult to be confident the New Zealand economy is firmly on the road to recovery, although some of the partial economic indicators have started to look a little more positive over the last few months. Our central forecast is for moderate growth to return during 2026, led by provincial areas and gradually finding its way into the likes of Auckland and Wellington. But we also see an increasing chance that growth pushes beyond our forecast of 2.3%pa in 2027 – good news at first glance, but ultimately putting the economy in a position where tighter monetary conditions are needed to bring growth back to a more sustainable rate. The ups and downs caused by significant swings in monetary or fiscal policy are arguably more challenging for businesses than adapting to demand sitting at a lower, but more stable, level.