Weekly Economic Commentary 28 November 2022
Analysis and forecasts of the economy and markets, along with previews of data for the week ahead.
Read full report here (PDF 1020KB).
It won’t happen overnight…
The Reserve Bank delivered a jumbo sized 75 basis point rise in the Official Cash Rate at its November meeting. The central bank also signalled that the cash rate is likely to rise much higher in the months ahead. We have revised up our forecast for the OCR and now expect a peak of 5.50% in early 2023. For New Zealand households, that signals big increases in borrowing costs. And as those higher interest rates ripple through the economy, we’re likely to see growth slowing and unemployment rising.
We have revised our forecast for the Official Cash Rate higher. We now expect a 75 basis point rise in February, and a further 50 basis point rise in April (previously we had expected increases of 50bp and 25bp respectively at those meetings). Those increases would take the OCR to a peak of 5.50% – its highest level since 2008.
Behind that change in our OCR forecast has been ongoing strength in inflation, and a related hawkish lurch from the RBNZ. The central bank delivered a 75 basis point rise in the Official Cash Rate at its November policy meeting. That was the largest ever increase in a single meeting, and it follows a series of large increases in the cash rate over the past year. In fact, the cash rate has now risen by a total of 400 basis points since the tightening cycle began in October last year.
And the RBNZ isn’t slowing down. It has signalled that further large increases in the cash rate are coming in short order. From here, the central bank is projecting the cash rate to peak at 5.50%. That’s a significant upgrade from the peak of 4.1% they had expected back in August.
Prices are charging higher in nearly every corner of the economy, with the Consumers Price Index rising by 7.2% in the year to September. That was a much larger increase than the Reserve Bank had expected. Importantly, the drivers of inflation have changed over time. Price rises were initially related to supply disruptions and increases in import costs in the wake of the pandemic. However, it’s domestic factors that are now driving much of the strength in inflation that we’re seeing. That includes the strength of domestic demand. It also includes the tightly stretched labour market, with wage costs rising rapidly as businesses have struggled to attract and retain workers.
Crucially for the RBNZ, households and businesses increasingly expect that inflation will remain elevated despite the rise in interest rates. And that is a big worry for the central bank. Expectations, especially over longer horizons, are a key influence on how businesses adjust prices and wages, and their recent rise means that the current inflation cycle could be even more protracted. Indeed, we are already seeing signs of a wage-price spiral emerging. Average hourly earnings rose by 7.4% over the past year with the very low level of unemployment giving workers greater bargaining power. And the strength of activity means that businesses have been willing to pay (and pass on) those higher labour costs.
Interest rate increases to date have started to weigh on domestic activity. That’s been seen most clearly in the housing market, with sales dropping to low levels and prices down an average of 12% from their peak in November 2021. Nevertheless, overall economic activity remains elevated. In fact, the latest retail spending figures have shown that households are not winding back their spending despite mounting financial pressures. Instead, nominal spending levels were up another 2.5% in the three months to September. In addition, core inflation measures (which track the underlying trend in prices) have continued to push higher despite rate increases over the past year.
To get the inflation genie back in the bottle, it’s clear that demand needs to soften. In fact, the RBNZ is forecasting that a recession will be needed, and is projecting falls in economic activity from mid-2023 to early 2024, along with a related rise in unemployment.
But we think a note of caution is needed here. Although inflation has been resilient to interest rate increases thus far, there should be no mistake – monetary policy is still effective. However, it takes time for interest rate changes to affect demand and inflation. To borrow a phrase, it won’t happen overnight, but it will happen.
A key reason for that is because the vast majority of New Zealand mortgages are on fixed interest rates, which has shielded them from interest rate increases to date. Many borrowers are still on the very low rates that were on offer during the early stages of the pandemic.
That picture will change dramatically over the coming year. Over the next 12 months, more than half of mortgages will come up for repricing, and many borrowers will face interest rate rises of 2% or more. That will certainly pull down spending and employment. And it could also see the current strength in domestic inflation dissipate more quickly than the RBNZ expects.
Consistent with that, we now expect OCR cuts to begin in early 2024, six months earlier than we did previously. Those rate cuts are both earlier and faster than what the RBNZ is projecting.
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