Weekly Economic Commentary 27 March 2023
Analysis and forecasts of the economy and markets, along with previews of data for the week ahead.
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When the tide goes out.
A clutch of bank failures has put global markets on edge in recent weeks. If this were to blow up into a wider issue, past experience shows that New Zealand could find it harder and costlier to fund itself from overseas, and global growth would be undermined. But as long as the pressures remain contained, the Reserve Bank’s focus can remain on the battle against inflation.
The closure of Silicon Valley Bank, along with two other regional US banks, earlier this month sparked a crisis of confidence in the banking sector. Concerns about contagion – the risk that investors and depositors start to withdraw indiscriminately, potentially putting otherwise healthy banks in distress – led authorities to provide a range of assurances and support measures. Those interventions have been effective so far, and global markets have been calmer in recent days.
Time will tell whether this proves to be the last of the banking sector concerns. Global interest rates have risen substantially in the last year or so. This will inevitably shake out bad investments and bad practices that flourished during the period of extraordinary low interest rates following the Covid shock. For instance, Silicon Valley Bank was among the first banks to fail because, as it turned out, it had done an exceptionally poor job of managing its interest rate risk.
Where this could become a more serious issue for New Zealand is if investors’ appetite for risk dries up, and they instead focus on shoring up their own positions. When this occurs, capital tends to flow back to its home markets. And for the most part, ‘home’ is not New Zealand – we have long been a net borrower on the world stage.
Indeed, just as we were before the 2008 Global Financial Crisis, we are very reliant on international markets to fund our spending behaviour at the moment. Figures released earlier this month showed that our current account deficit has widened to 8.9% of GDP, from as little as 1% two years ago.
The blowout in the deficit has been due to multiple factors: the loss of overseas tourist earnings during the border closure, rising world prices for our imports, and a sharp rise in shipping costs. But the overriding factor is that we have not adjusted our spending to account for these shocks. In fact just the opposite – demand in the domestic economy, including demand for imported goods, has been running hot in the last couple of years.
A loss of risk appetite among global investors would force a narrowing of this deficit, through two potential channels. The first would be a sharp drop in the New Zealand dollar, until it reached a level that made it attractive to investors again. This would actually worsen the deficit initially, as the dollar value of exports, imports, and the (negative) balance would all increase. But over time, this would help to boost export volumes and reduce demand for imports.
The other potential channel is that New Zealand banks and business would find that overseas funding becomes more expensive and harder to come by. That means higher interest rates, independent of what the Official Cash Rate is doing. This would slow the economy and reduce the demand for imports. Indeed, it’s possible that market interest rates could rise by more than what the Reserve Bank intended, in which case it may have to adjust its path for the OCR accordingly.
At this stage, though, there’s no sign of these sorts of pressures emerging. So the Reserve Bank’s interest rate decisions can stay focused on the fight against inflation.
As the RBNZ’s chief economist noted in a speech last week, that fight remains incredibly challenging. The inflation rate remains close to a three-decade high, and more worryingly, the drivers of inflation have evolved. The initial spike was mainly due to large price rises in a relatively small number of largely imported items. However, we are now seeing price rises across a wide range of goods and services, and increasingly driven by local rather than global forces.
Against this, the RBNZ’s response to inflation is now well advanced. The OCR has been rising since October 2021, and has finally reached a level that the RBNZ considers to be contractionary. There are some early signs that this is having the desired effect, and that demand in the economy is starting to cool off.
Even so, there is a lot of water to go under the bridge before we can be confident that inflation is coming back under control. Firms are still facing a range of cost increases, workers are still in short supply and the upward pressure on wages remains strong. We recently revised our OCR forecast to a peak of 5% this year, with one further 25 basis point increase at the next review in April. However, with the RBNZ continuing to talk tough on inflation, the risks lean towards further cash rate increases beyond that date.
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