Inflation remains 'uncomfortably high' as New Zealand's economic growth predicted to slow in year ahead - Westpac

The New Zealand economy has lost steam and economic growth is predicted to slow over the year ahead, a report has found.

Westpac's latest Economic Review found that while inflation pressures are starting to soften, it is still "uncomfortably high".

The bank's chief economist, Kelly Eckhold, said "big question marks" remain about how easy it'll be to bring inflation back inside the 1-3 percent target range and if the economy will slow sufficiently to make this happen fast enough.

"Getting inflation back to sustainable levels won't be easy, especially since the economy likely won't slow as much as we feared a few months back," he said.

"Net migration has rebounded faster than expected and population growth is set to rise to its highest level in decades. These new entrants will bring valuable skills to a stretched labour market. However, they will also add to demand pressures in the economy and offset some of the impact that rising interest rates are having."

Eckhold said it's less likely we'll see New Zealand's economy tip into outright recession, adding the house price cycle looks to have bottomed out sooner than expected.

"None of this takes away from the point that the interest rate cycle is very mature and the peak in interest rates is near. The extra bit of work we think is required is very much in the vein of a stitch in time saves nine."

The New Zealand economy

Westpac's report found that several of the factors that boosted growth in recent years have now moderated or even reversed. Most significantly, a sharp rise in interest rates combined with large increases in household living costs is restraining domestic demand.

At the same time, the pace of the rebound in international tourism has slowed after the initial surge in visitors when the borders reopened. And on top of that, parts of the economy have been grappling with the aftermath of the devastating storms in January and February.

"We estimate that economic output fell by 0.8 percent over the December and March quarters combined. That might fit the label of a 'technical recession' (that is, two consecutive quarters of falling activity). However, we don't think this represents an actual recession in the New Zealand economy," the report said.

"The labour market remains strong and businesses are continuing to take on staff. In addition, much of the downturn in the March quarter reflects temporary disruptions caused by the recent storms.

"Nevertheless, the slowdown in activity over the past few months does highlight that the ground beneath the economy has become increasingly soggy, with the sharp rise in interest rates over the past year now clearly weighing on demand."

Going forward, they expect the rapid economic growth seen in the wake of the COVID-19 lockdowns will now give way to an extended period of subdued growth. 

Right now though, Westpac said the major factor that is squeezing households' finances and weighing on economic growth is the large rise in debt servicing costs. In response to strong inflation pressures, the Reserve Bank has continually hiked the Official Cash Rate.

Stacks of coins on graph paper background with red arrow.
Photo credit: Getty Images

While widespread mortgage rate fixing insulated many borrowers from the impact of those increases for a short time, Westpac said large numbers of mortgages have now rolled on to higher interest rates.

"In fact, accounting for the extent of interest rate fixing, we estimate that the average 'effective' mortgage rate that New Zealand borrowers are actually paying has increased by around 120 bps since early 2022," they said.

"Around 50 percent of all fixed-rate mortgages will come up for repricing over the year ahead, and the average mortgage rate is set to rise by a further 150 bps by early 2024. That will see the average household's spending on interest costs increasing from around 5 percent of their disposable income in 2022 to 10 percent in 2024, and some borrowers will face much larger increases."

With higher interest rates along with rising living costs, Westpac said these will drain households' wallets and many will be forced to wind back their spending over the coming year.

"While spending levels in the economy have continued to push higher in recent months, this mostly reflects the impact of price rises - households are having to splash out more cash, but are getting less bang for their buck," Westpac said.

"Even so, the resilience in retail spending has been notable, and highlights that the current strength of the labour market is helping to insulate many households from the other factors squeezing their finances.

"In fact, with high levels of economic activity and very low unemployment, average hourly earnings have risen by more than 7 percent over the past year, broadly keeping pace with the rise in living costs."

But Westpac predicted the labour market will eventually run out of steam as economic conditions turn down more generally. They expect unemployment to rise from its current level of 3.4 percent to 5 percent by the start of 2025.

Inflation and the Reserve Bank

Westpac said inflation is now "past its peak". Consumer prices rose by 1.2 percent in the March quarter, which saw the annual inflation rate dropping from 7.2 percent at the end of last year to 6.7 percent now. Annual inflation hasn't been this low since the end of 2021.

But what they said is more important is inflation has now fallen "well short" of the RBNZ's forecasts for the past two quarters. The RBNZ forecast that annual inflation would rise to 7.3 percent in the March quarter. 

While there's been a dip in headline inflation, Westpac said it's too soon to celebrate victory.

"We can take some small comfort, however, from the fact that while price pressures remain strong, they aren't accelerating," they said.

"Measures of 'core' inflation, which smooth through the quarter-to-quarter volatility in prices, have stabilised around 6 percent and some measures are easing. 

"Furthermore, it's also notable that the early part of 2023 saw widespread falls in the prices of many imported durable items, like furnishings and appliances, as well a further easing in the cost of purchasing a newly built home (which drove much of the rise in overall inflation over the past year)."

These are both areas they would expect to see price pressures soften following the sharp rise in interest rates over the past year.

In terms of RBNZ and the OCR, Westpac believes the OCR will rise to 6 percent by August and remain there until mid-2024, when they said it should be clearer that inflation pressures have substantially moderated.

By then, CPI inflation should be closer to 4 percent and the prospect of reaching 3 percent inflation will become "more than just a figment of an economic forecaster's wild imagination".

"As always, significant risks to this central outlook exist - but our sense is that these remain to the upside in terms of inflation persistence and hence interest rates," Westpac said.

"A key upside risk is the size and amplitude of the migration cycle we are now firmly within. We have included a reasonable assessment of what might be expected but if a greater and more protracted migration cycle eventuates then we would expect the net demand impact on the economy and inflation to be greater and more persistent."

But if inward migration triggers an early return to a strong housing market, then Westpac said the resulting boost to consumption, investment, and the labour market could really challenge the assumption that inflation expectations remain anchored to the 1-3 percent target range.