Rapid escalation for New Zealand economy - Westpac

Introducing Westpac's August Economic Overview, Michael Gordon, the bank’s Acting Chief Economist, says:

‘Our forecasts have been through some rapid changes since our May Economic Overview, as the New Zealand economy has revealed new facets to its post-Covid recovery. 

'We’ve noted for some time that Covid-19 has been constraining the supply side of the economy. That’s included rising prices for materials, disruptions to global manufacturing and shipping, and the loss of access to migrant workers due to the border closure.

'What was lacking, even up until a few months ago, was a sense that businesses were able to pass on cost increases, or to bid up pay rates to attract local workers. But that’s changed in a big way. It’s now clear that demand is running hot as well, and that means the stimulus the Reserve Bank provided last year to support the recovery is no longer needed.

'We expect the Reserve Bank to begin raising the OCR from its record low over the coming months. That would put it well ahead of its overseas peers, but that’s a fair reflection of the unique circumstances that New Zealand faces. Our Covid elimination approach has allowed the economy to gather a head of steam, more so than we’ve seen elsewhere.’

Here are some talking points from the report – read the full Economic Overview here. 

The New Zealand economy

The New Zealand economy has surpassed all expectations in recent months, with domestic activity growing in leaps and bounds. The economy powered through summer even without the usual peak in tourists, and it looks to have gained further momentum on top of that. There has also been a much faster than expected tightening in the labour market, with unemployment dropping to just 4% in the June quarter, equal to the cycle low that we saw in 2019.

Of course, there are still some soft spots. Most notably, the continued closure of our borders has meant that spending in sectors like travel, accommodation and entertainment still remains someway below pre-Covid levels. This has also meant that the recovery has been uneven across regions: international tourist hotspots like Queenstown have lagged regions which have a larger agricultural backbone and those that focus on providing services for the domestic economy.

The economy is set to continue growing at a brisk pace over the coming year, with businesses in the construction, manufacturing and services sectors all reporting solid levels of forward orders. The continuing, albeit tenuous recovery in the global economy also bodes favourably for export earnings.

Supply chains

One of the other significant challenges that businesses have been wrestling with are ongoing disruptions to global shipping and supply chains. That’s resulted in deliveries of raw materials failing to keep pace with orders in recent months. It’s also contributed to shortages of many consumer goods as household spending has picked up.

Disruptions to global manufacturing and shipping now look like they will be more persistent than previously anticipated. The spread of Covid and its variants continues to disrupt economic activity in many regions, particularly in Asian economies that are major producers of finished consumer goods. At the same time, demand is picking up in large economies like the US, and shipping companies have diverted capacity away from New Zealand towards more profitable routes.

Covid

For New Zealand, the continued spread of Covid and its more virulent variants has a number of important implications. First is that border restrictions are now expected to remain in place for longer than previously assumed, with the suspension of the trans-Tasman travel bubble potentially extending well beyond the initial 8 weeks that’s been stipulated. More generally, widespread travel with other countries is unlikely to open before mid-2022. And even then, border openings are likely to be gradual and on a selected risk-based basis. As a result, industries that are closely linked to the international border, like tourism and accommodation, are likely to face tough trading conditions for some time yet.

What would happen if we had another outbreak onshore? Over the past year, we have had periods where the Alert Level was dialled up in some regions. While that did cause some disruptions, economic activity has proven to be fairly resilient, with increases in the Alert Level often resulting in spending being delayed, rather than cancelled.

However, the Delta variant is proving to be more contagious and harder to contain. Should it arrive on our shores, this raises the risk that health restrictions could be imposed for longer or that they are stricter than during previous incidents. That would risk major disruptions to economic conditions and the labour market. It would also raise the possibility that  additional monetary and fiscal stimulus could be (re)introduced. 

A special topic in the Overview looks at Life after Vaccination - how might this play out? (see page 10 of report)

House prices

We expect that house prices will continue to rise over the coming year, but that the pace of increase will slow as mortgage rates lift from their recent lows. Longer term, mortgage rates are set to continue rising, back towards more average levels. After the recent period of very low mortgage rates, that’s likely to take some of the steam coming out of the housing market. And combined with changes to the tax system, the middle part of the decade is likely to see some modest price declines.

Inflation

We expect annual inflation to peak at 3.8% in the September quarter this year, and to remain above 3% through to the early part of next year. Some of that strength is due to base effects: the sharp rise in prices in the June quarter will boost the annual rate for the coming year, just as the price falls during the Covid lockdown kept the annual rate low over the previous year. We expect inflation to settle around the RBNZ’s target from late 2022 – conditional on higher interest rates.

As we move towards the end of 2022, we expect inflation to settle around the 2% midpoint of the RBNZ’s target band, which itself would be a more sustained period of inflation than we’ve seen for some time. However, those forecasts are predicated on a rise in interest rates over the next few years; in the absence of action by the RBNZ, there would be a greater risk of inflation expectations becoming unanchored, and a spiral of larger wage and price increases taking hold. 

In light of these risks, we’ve significantly brought forward our forecasts of interest rate hikes since our last Economic Overview. We expect the RBNZ to increase the OCR by 25 basis points at each of the next three reviews in August, October and November, which would take the cash rate to 1% by the end of this year.

Download the full Economic Overview here

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