Weekly Economic Commentary 29 May 2023
Analysis and forecasts of the economy and markets, along with previews of data for the week ahead.
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Mission accomplished? Yeah… nah.
While the Reserve Bank of New Zealand delivered the expected increase in the Official Cash Rate at its May meeting, the central bank’s assessment of economic conditions was much more dovish than we expected. We continue to expect that the cash rate will need to rise further to bring inflation back to target. However, given the tone of the RBNZ’s policy outlook, we have revised down our forecast for the peak in the cash rate to 5.75% (from 6.00% previously).
As expected, the Reserve Bank of New Zealand hiked the Official Cash Rate by 25bps at their May policy meeting, taking the cash rate to 5.50%. However, in contrast to our own and market expectations for a hawkish tilt from the central bank, the tone of the RBNZ’s policy assessment was surprisingly dovish. Most notably, the RBNZ continues to assume that a peak cash rate of 5.50%, if held for long enough, would be sufficient to bring inflation back to target.
In contrast, we think that the cash rate will need to rise further from here, especially given the boost to demand from the current surge in migration. However, given the RBNZ’s dovish stance, we have revised down our forecast for the OCR. We now expect that the OCR will rise to a peak of 5.75% (down from 6.00% previously) with that final 25bp rise coming in August.
Digging into the details of the RBNZ’s policy assessment, the central bank is conscious of the same factors that we have been highlighting, most notably the squeeze on households’ purchasing power from higher living costs and increases in interest rates. However, while we agree that those tighter financial conditions will be a significant drag on demand, we think the RBNZ may be overestimating just how much demand will soften. In fact, if we look at the RBNZ’s assumption for per-capita spending growth, the central bank expects that rate hikes to date will see spending dropping even more sharply than during the 2008/09 Global Financial Crisis.
Even though there will be a good deal of belt tightening from households over the coming months, we’re not as pessimistic as the RBNZ is on this front. A key reason for this is the state of the labour market – employment levels remain high, and rising wages are helping to support household spending. And although we do expect the labour market will cool over time, we expect that the downturn will be more modest than the RBNZ has assumed (especially if the RBNZ stays on hold, as their forecasts imply).
On top of this, the current surge in migration inflows signals a material upside risk to the RBNZ’s forecasts. The RBNZ’s migration forecasts are actually quite similar to our own. But the big question is what this means for the balance of demand and supply conditions in the economy. And to be fair, the RBNZ acknowledged there is some uncertainty around how those pressures will evolve. However, we think that the surge in net migration will ultimately result in stronger inflation pressures than the central bank expects.
Notably, the RBNZ seems to be putting a lot of weight on the idea that migration will ease the labour shortages that have plagued the country for the last few years. They note that job advertisements have fallen substantially from their mid-2022 highs, as New Zealand’s border was reopened and the surge in migrants began.
However, job ads are not weak by any means. Although they have come down, they’re still substantially above pre-Covid levels. The demand for workers remains strong and, as the March quarter labour force survey showed, employment is still outstripping population growth.
The RBNZ has also downplayed the impact of migration on the housing market. Housing is the part of the economy where migration is most obviously a net inflationary force as the supply of new homes is relatively unresponsive to population changes (at least in the near term). This pressure on house prices occurs regardless of whether migrants are buying or renting, since somebody has to own the houses that they rent.
Putting this altogether, it’s likely that domestic demand and inflation pressures will prove stronger than the RBNZ expects. However, it will take some time – likely not until late this year – before the strength of those pressures becomes obvious. The key area to watch will be the housing market. The RBNZ is forecasting a further 3.5% fall in house prices over the next year before they bottom out. However, the most recent REINZ sales figures hint that the turn in the market may have already arrived. The upturn in house prices in Australia – which has seen a similar resurgence in net migration – should serve as a warning for what might come next here.
A complicating factor is that, even with the RBNZ’s lower OCR forecast, inflation is still set to fall sharply over the next few months. That’s because some of the very large cost increases that we saw in the wake of the pandemic (many of which were due to temporary supply side disruptions) are now dropping out of the annual inflation figures. That will pull headline inflation down from close to 7% currently to around 4.5% by the end of this year. But underlying that is a picture of more persistent domestic inflation pressures. And if the RBNZ doesn’t take the OCR higher from here, it’s likely that those domestic inflation pressures will linger, meaning interest rates will also likely need to remain higher for longer.
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