State of the nation

The last few years have been a wild ride for the New Zealand economy. GDP growth went off the charts when the lockdowns happened, and even now, the after-effects of the chaos of the COVID period continue to ripple through the economy. 

No wonder things are volatile, with the economy having faced:

• Unprecedented supply-side disruption – not only short-term lockdowns, but also longer-running disruptions to shipping and to the ability to import labour
• Unprecedented monetary stimulus, with a record-low Official Cash Rate (OCR) and quantitative easing, followed by the most rapid increase in the OCR ever seen
• Enormous fiscal stimulus
• The most extreme house price cycle in decades
• Extreme weather
• Very large swings in our commodity prices.

All the noise has not made it any easier for the Reserve Bank (or any other forecaster) to discern trends in a timely manner. But recent data confirms that monetary policy is working, with aggregate supply and demand coming back into balance perhaps a little faster than we previously expected. Yet the inflation-fighting job remains far from done. 

Monetary policy is successfully cooling the economy, but stimulatory fiscal policy and the demand-side impacts of record-high migration are slowing progress in some areas. We expect the economy to continue to cool, as a soft underbelly for domestic demand more than offsets the ongoing net exports recovery (with international tourism and education continuing to recover and import demand softening). 

All the noise has not made it any easier for the Reserve Bank (or any other forecaster, for that matter) to discern trends in a timely manner. But recent data confirms that monetary policy is working, with aggregate supply and demand coming back into balance perhaps a little faster than we previously expected. Yet with annual CPI inflation still at 5.6% versus a target of 1-3%, the inflation-fighting job remains far from done. 

Monetary policy is successfully cooling the economy, with the construction and retail sectors feeling the pinch more than others, and per-capita growth is weak. But stimulatory fiscal policy, the tourism recovery and the demand-side impacts of record-high migration are slowing progress in some areas, and the ANZ Business Outlook survey suggests businesses are optimistic the worst is over. That’s good news, but only conditionally – the question of how much the economy needs to slow to get inflation down remains subject to great uncertainty. For our part, we expect the economy to continue to cool, as a soft underbelly for domestic demand more than offsets the ongoing net exports recovery – international tourism and education continue to recover and import demand is softening, seeing the trade balance start to narrow from very wide levels. 

While there’s been real progress, it’s still a long road to the 2% CPI target midpoint from here, and a lot of ducks have to stay lined up for quite some time yet: oil prices, inflation expectations, the housing market, and the labour market. Overall, while recent data confirming the turn in the labour market has seen us take further hikes out of our forecasts, we still wouldn’t rule the possibility out and the RBNZ certainly isn’t either. 

Here and now, the RBNZ remains nervous about high inflation, but things are going in the right direction. There is genuine uncertainty about whether the economy remains on the skids, or whether things are starting to bottom out. Some of the data we’ll be watching particularly closely includes:

• More evidence on the demand impact of massive net migration (and behind the net numbers, enormous churn, with the numbers going in and out both enormous), particularly on the housing market (rents and house prices)
• New Zealand’s export commodity prices
• Whether the improvement in business sentiment seen over the year continues, or whether the lagged impacts of monetary policy mean the shoe is about to drop.

We now have a new Government, and the policy prescription has landed. Overall, there are changes that benefit farmers, and residential property investors, potentially providing a little upside to house prices but downside to rents. Overall, the Government appears to want to deliver National’s planned tax cuts but without the $700 million of planned revenue from selling residential property to foreigners. The tax cuts will therefore need to be funded by spending cuts elsewhere, but where the axe will fall is largely yet to be determined.  

The outlook for the housing market is worthy of a little more discussion. But it’s important to note that our forecasts imply house prices barely keeping up with incomes over the next few years. With mortgage rates much higher than they were, the amount people can borrow for a given level of income has fallen sharply over the past two years. That puts a speed limit on the current rebound in the housing market – as does the deteriorating labour market. 

However, population growth in excess of 2% is a powerful tailwind, particularly for the Auckland market, and tax and tenancy rule changes are favourable for property investors. The Auckland market is famous for having nine lives, and with prices still well below their peaks, there could be a reasonable number of buyers who can smell a ‘bargain’ – for all that house price to income ratios remain eye-wateringly high. 

The RBNZ could respond to any discomfort about growth in riskier lending with tighter restrictions on high-loan-to-value lending (with the restrictions on investors being particularly potent) and possibly also debt-to-income limits from mid-2024. And of course they could also put the brakes on the housing market very effectively by resuming OCR hikes. If broader economy is weak, a little bit of capital gain is unlikely to change the picture. But if things get to the point where the vibe of the domestic economy is starting to turn markedly upward before the back of inflation is broken, the RBNZ would likely have to respond. For now, though, while the market has picked itself up off the floor, it remains sluggish, and our expectation is that it will remain so for some time.

Overall, we see the economy muddling through, with some unders and overs, and certainly winners and losers as the big forces (monetary, fiscal, global and demographic) that are buffeting the economy play out. But unfortunately it’ll likely feel like hard yards overall for a while – a soft landing is still a landing. Strong population growth is masking the weakness in per capita spending as people watch their pennies. We see the unemployment rate continuing to rise. And the agricultural sector is contending with a significant reduction in incomes with export prices low and operating costs (including interest costs) sharply higher. 

But hopefully, the reward for all this restraint will be steadily falling inflation and an improving balance both fiscally and with the rest of the world that will set the economy up for future success. At the end of the day, we have lived beyond our means for a period, and a corresponding period of tightening the purse strings was always inevitable. With much of the globe going through a variation of the same theme, risks of a sideswipe are real. But so far, the soft landing remains on track. We’ll take that.