Weekly Economic Commentary 3 October 2022
Analysis and forecasts of the economy and markets, along with previews of data for the week ahead.
Read full report here (PDF 1MB).
The good, the bad, and the currency.
We’ve revised up our forecast of how high the Official Cash Rate will need to go in the Reserve Bank’s battle against inflation. We now expect a peak of 4.5%, compared to our previous forecast of 4%. We expect the RBNZ to reach this point with a 50 basis point hike at this Wednesday’s policy review, followed by another 50 basis points at both the November and February reviews.
Recent developments in the New Zealand economy have been mixed, but on balance have pointed to ongoing resilience in activity. First up is GDP which grew by 1.7% in the June quarter. The main contributor to that growth was a surge across the services sectors, as New Zealand reopened its border to overseas tourists. That pace of growth is unlikely to be repeated, but it’s a potent reminder that key parts of the economy are still in recovery mode, even as we see signs of cooling in the parts that had become overheated.
As we’ve moved through the back part of the year, the signs of cooling demand that the RBNZ has been looking for have started to emerge, and the household sector is bearing most of the brunt of the adjustment as we expected. House prices have continued to soften in the face of higher mortgage rates, and are now down around 9% from their peak last November. We’ve also seen a flattening off in nominal consumer spending (at a time that prices have been rising rapidly), and consumer confidence is languishing at low levels. Finally, the effective average mortgage rate paid by homeowners has continued to push higher, and is set to continue rising over the coming months.
But while some steam has come out of the economy, activity is still trucking along at a solid pace. That’s been reflected in the latest PSI and PMI reports, which pointed to resilient demand and a lift in forward orders. Similarly, the labour market remains strong, with continued growth in filled jobs and job advertisements over recent months.
We’ve also seen positive developments in our export sectors. Prices for our commodity exports have held firm, with world dairy prices rising 7% over the past month alone. At the same time, international visitor arrivals have been climbing rapidly since the reopening of the borders.
The more significant developments for the monetary policy outlook have been on the global stage. With inflation boiling over around the world, policy rates in major economies have been charging higher in recent months. At the same time, geopolitical tensions, including the Ukraine war and an escalation in Russian rhetoric, are rippling through financial markets. And on top of those developments, the sustainability of the UK’s longer term fiscal position has been thrown into question following the announcement of significant stimulus measures.
As a result, global investors have flocked to the perceived safe haven of the US dollar. That’s come at the expense of currencies such as the New Zealand dollar in particular – we’ve fallen by more than 10% against the USD in recent weeks, and have lost ground to a lesser degree against others like the euro and the Australian dollar.
We had been forecasting the US dollar to ease back again over the next couple of years, as worldwide inflation rates passed their peaks and global markets became more comfortable that central banks were getting on top of the problem. However, that point is now looking more distant. So in addition to the lower starting point, we now expect a later and more subdued recovery in the New Zealand dollar. We expect the New Zealand dollar to remain below 0.60 against the USD through to the middle of next year, only rising to 0.67 by 2024.
A lower New Zealand dollar does come with some benefits to the economy, boosting our export earnings and providing some insulation from the headwinds to global growth. But it also means higher costs for imported consumer goods and production inputs, adding to inflation over the year or so ahead.
As a rule of thumb, a sustained 10% drop in the New Zealand dollar would add around 0.4% to the rate of inflation for the following year. This comes at a time when inflation is already expected to be outside the RBNZ’s medium-term target range of 1-3% for an extended period.
The real issue, however, is the risk of second-round effects, as higher headline inflation can act as a catalyst for further price increases. The risk of that occurring is much greater when the economy is stretched thin, or if there is a large and persistent rise in inflation. And that’s exactly what we’re seeing now. In addition to businesses raising their prices to maintain margins, wage growth has risen sharply as workers have sought compensation for the large increases in the cost of living. Now, with a stronger outlook for consumer prices, that pressure on wages (and other operating costs) is likely to be even more intense.
Like the RBNZ, we had previously judged that an OCR of around 4% would be enough to bring inflation back to the target range within a medium-term horizon – but only barely. There was little room for the RBNZ to absorb any further upside surprises on inflation before it would have to revise its OCR track higher as well.
This week’s decision won’t include a new set of forecasts, so any change in the projected path for the OCR will have to be conveyed verbally. We expect the RBNZ to repeat its recent language that it will continue to tighten monetary policy “at pace”, and may say that the Committee anticipates a higher OCR path than what was projected in the August statement.
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