21 Jan 2022
Global inflation risks have intensified over the past few months but front-loaded official cash rate (OCR) hikes by the Reserve Bank of New Zealand (RBNZ) have mitigated domestic inflation risks.
Many other central banks across the globe are now underway with their tightening cycle too and making all the right noises. ANZ Research fully expects them to tame inflation in time. The question is, how much tightening will it take and how much economic pain will it require?
“Kiwis need to continue to look beyond GDP for a steer on economic momentum. And there are plenty of indicators suggesting underlying momentum is slipping.”
Indeed, on the activity side, it very much feels like one-way traffic. War, COVID-19 in China hitting dairy prices, a further global pivot towards tighter monetary settings, still-accelerating inflation, biting capacity constraints (including within many global labour markets), falling house prices and weak consumer and business confidence all suggest downside risks to the activity outlook.
Some economic indicators are looking rather downbeat right now but COVID-volatility is making it hard to separate the noise from the signal.
Near term, the gross domestic product (GDP) data will be noisy. Lockdown impacts in Q3 (which saw the economy contract 3.6 per cent quarter-on-quarter) partially unwound over Q4 (a 3.0 per cent rebound) and should continue unwinding through the Omicron-ravaged Q1. However, it’s possible Omicron pushes some of this bounce into Q2. But provided New Zealand manages to avoid lockdowns in 2022, GDP data should settle down over the second half of the year (Q3 GDP is released December 2022).
That means Kiwis need to continue to look beyond GDP for a steer on economic momentum. And there are plenty of indicators suggesting underlying momentum is slipping.
Take ANZ’s Consumer Confidence survey and the question within it of whether it’s a good time to buy a major household item. This indicator tends to provide a very good steer on momentum in retail activity which in turn tends to provide a very good steer on overall domestic demand. Right now it’s very soft – softer than during the 2008/09 recession which is not a time retailers remember fondly.
ANZ Research’s Business Outlook suggests residential construction is poised to slow. That’s exactly what you’d expect when house prices and sales are contracting. However, building consents continue to push record highs, driven recently by multi-unit dwellings.
While that suggests the construction pipeline is full, rapid building cost inflation, construction delays and difficulty achieving presales as house sales and prices fall could very well see some of these consented projects scrapped. Anecdotally, that’s happening already.
There are other reasons to think tougher times lie ahead:
All up, the drivers of economic momentum are particularly complex right now. A lot hinges on the labour market holding it together but even if it does the composition of the economy won’t be the same.
Putting it all together, we land on an economic outlook that’s likely to feel very different for many households than the past couple of years. Private consumption is expected to slip as a share of the real economy as the demand impulse from the tight labour market reaches its limits and high inflation, higher interest rates and a slowing housing market bite.
The Government consumption share of GDP still has a little further to climb as more stimulus was delivered in Budget 2022. However, ANZ Research sees significant limitations on how much additional government spending can achieve in real terms given the degree of capacity stretch in the economy right now.
Investment is another key driver of domestic demand and one that tends to be very sensitive to interest rates. But government investment (which ANZ Research estimates accounts for around 15 per cent of total investment) is more likely to look through rising rates. All up, ANZ Research expects both residential investment and other investment shrinking only mildly as a share of GDP over the forecast horizon as rates rise but a harder landing in housing (and the broader economy) than anticipated would very likely see investment underperform.
Overall, 2022 (which still has some post-lockdown bounce to deliver) should see growth come in close to trend (2.5 per cent over the year to December). But 2023 (2.1 per cent) and 2024 (1.7 per cent) are expected to be softer.
High inflation was confirmed in the Q1 data (6.9 per cent year-on-year). While there are some significant inflation pressures stemming from global developments, the ongoing intensification in domestic inflation pressures is the primary concern for the RBNZ.
Non-tradables inflation (aka domestic inflation) lifted to 6.0 per cent, up from 5.3 per cent in Q4. This is the sticky kind of inflation that tends to hang around and is difficult to tame. Core inflation measures are also on a tear and convincingly outside of the RBNZ 1-3 per cent target band.
ANZ Research expect OCR hikes, supported by the general monetary tightening underway globally, will successfully take the heat out of inflation in time.
Tradable inflation will slow alongside global developments (there’s already evidence of weakening orders for Chinese manufactured goods which should see shipping costs soon start to fall). But it will take a loosening in the labour market and a housing slowdown to tackle non-tradable (domestic) inflation – that’s a longer-term project.
Having hiked 50 basis points in April, the RBNZ is now well and truly underway, with 125 basis points of hikes already under its belt, whereas some global central banks are only just getting started. ANZ Research expects a second 50 basis point hike in May, taking the OCR to 2 per cent.
Based on the RBNZ’s current thinking (something ANZ Research really needs to keep a very close eye on, as it could change), 2 per cent is a bit of a magic number for the OCR.
It’s the RBNZ’s most recently published (highly uncertain and time-varying) estimate of the neutral OCR – that’s the OCR consistent with stable, close-to-target inflation over the medium term. The RBNZ’s strategy currently appears to be to get to neutral quickly and then take it more gently from there, given the lags with which monetary policy operates. So any change in the estimate of at what interest rate the foot moves from the accelerator to the brake will have consequences for the likelihood of a third 50 basis point hike in July.
To really deliver a knock-out punch to inflation, ANZ Research thinks the RBNZ will need to take the OCR into contractionary territory (ie above neutral) as it has already signalled it will do. Following May’s 50 basis point hike ANZ Research expects to see a series of back-to-back 25 basis point hikes taking the OCR to 3.5 per cent by April 2023. In acknowledgement of the risk the RBNZ might need to do more, ANZ Research have extended expectations for how long the OCR might need to stay at 3.5 per cent. Previously, the team had the OCR gradually “normalising” from early 2024 but have since pushed this out to the second half of 2024.
It’s hard to overstate the uncertainty about where the OCR will peak and/or how long it might need to stay there. On the one hand, getting on top of 7 per cent inflation with ‘just’ a 3.5 per cent OCR would be quite the achievement, given the OCR typically peaks well above inflation. On the other hand, the RBNZ is hiking into the teeth of an already rapidly weakening housing market and, in that context, it’ll be impressive if the wheels don’t fall off before the OCR gets that far (by early next year).
It’s a fine balance for the RBNZ as they weigh up the risk of oversteering (engineering a hard landing for housing, economic activity and inflation) against ensuring they prevent inflation pressures from spiralling out of control. At some point in the not-too-distant future, the OCR will be back at a level where these risks are a little more balanced and monetary policy decisions will be harder to make. Right now, the inflation-spiral risk is dominating and that speaks to another 50-pointer this month.
Markets are toying with another 50 basis point hike in July and while ANZ Research certainly can’t rule that out (the RBNZ may conclude it should get it done while the going is good), we do think the signs will be clear that monetary tightening is getting some traction by then.
All up, the rebalancing act the RBNZ and other central banks are currently performing is riddled with risks and uncertainties. But the one thing we can be sure of is that they will be successful in taming inflation, it’s just a question of how high (and for how long) rates need to go.
Miles Workman is Senior Economist at ANZ New Zealand
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
21 Jan 2022