That’s a wrap

It’s been quite a journey for the New Zealand economy over 2021, and our views have ended up in a very different position to what we expected at the beginning of the year. Supply-side shocks resulting from the Covid-19 pandemic have been a talking point throughout the year, but the greater challenge has been getting to grips with the role that strong demand is playing.

In some respects, the conditions were already falling into place at the start of the year. New Zealand’s successful approach to eliminating the first Covid outbreak had allowed the economy to quickly regain momentum, largely without restrictions on domestic activity. Substantial monetary and fiscal stimulus also played a major role, particularly in terms of income replacement and maintaining jobs during the lockdown period.

Early in the year, we moved away from predicting that further OCR cuts, including a move into negative territory, would be needed to support the recovery. Nevertheless, some substantial challenges still lay ahead, including a relatively more fragile recovery among our major trading partners, and the risk of further lockdowns while our vaccination rates remained low. What’s more, it was not clear how the economy would handle the loss of its biggest export sector – international tourism – during what would have been the peak summer period. As a result, we thought that the economy would continue to operate with spare capacity for some time. That meant that monetary policy would need to remain supportive, with the housing market being a major channel of transmission. The housing market was already running red-hot at the start of the year – in late 2020, when mortgage rates reached their low point, prices were rising as much as 3% a month. With interest rates remaining favourably low, we forecast that house price inflation would peak at 20% this year (the actual peak was 30%).

As a result, we thought that the economy would continue to operate with spare capacity for some time. That meant that monetary policy would need to remain supportive, with the housing market being a major channel of transmission. The housing market was already running red-hot at the start of the year – in late 2020, when mortgage rates reached their low point, prices were rising as much as 3% a month. With interest rates remaining favourably low, we forecast that house price inflation would peak at 20% this year (the actual peak was 30%).

Right from the start of the year there were concerns about escalating costs, largely as a result of Covid. There were stories of supply chain disruptions, soaring shipping costs and delayed deliveries, as well as skill shortages as the border closure cut off access to migrant workers.

But what was lacking was the evidence that businesses had the pricing power to pass on these cost increases. With the economy still operating below full capacity, we expected inflation to remain muted for some time as well. In fact, inflation was still low in the early part of this year, reaching just 1.5% in the March quarter, which was in line with forecasts.

However, in the following months the evidence was clear to see for all in the data, with inflation surging to 4.9% by the September quarter. Debate raged as to whether these price pressures would be transitory or longer-lasting, but much of the discourse continued to treat this as a supply-side shock.

We’ve maintained that demand is the greater determinant of inflation (in the sense of repeated price increases). And while the evidence of demand as a driver was initially lacking, it came through with a vengeance over the course of the year. Economic activity continued to surge, and by mid-year the level of GDP was 4.3% above its pre-pandemic level – even with lower population growth and the absence of international tourists. Similarly, demand for workers was surging. Job advertisements were far above pre-Covid levels, and by September we saw both record lows for unemployment and record highs for labour force participation.

Consequently, we now recognise that the monetary stimulus put in place in response to Covid will need to be withdrawn – and beyond to the point where monetary policy is outright tight. We expect the cash rate to reach 3% by late 2023. That doesn’t represent a permanently higher level of interest rates, but rather a temporary peak in the cycle, in order to cool demand back down to more sustainable level.

So looking to the year ahead, the key things we’ll be watching are:

Will wage growth accelerate? This is the other shoe that has yet to drop in this cycle. In a labour market this tight, you would normally expect to see upward pressure on (inflation-adjusted) wages, albeit with a lag. And while we have seen some uptick in recent months, it’s consistent with no more than a catchup after little or no pay increases during last year’s Covid shock. The demands for cost-of-living adjustments are only just beginning. And once they take hold, there’s a growing risk of an upward spiral in wages and prices, which could prove difficult for the Reserve Bank to dislodge.

How will the housing market respond to higher mortgage rates? We expect house price growth to slow substantially in the coming months, turning to modest declines from late 2022. Higher mortgage rates won’t be a strain for the majority of property owners, but they will significantly change the arithmetic for new purchases.

Can we safely reopen the borders? With the housing market, and therefore household consumption, expected to step down as drivers of growth next year, a key question is whether something else will step up – namely, international travel. Unfortunately, global trends in Covid make it uncertain as to when we’ll see tourists return in meaningful numbers. But even going from nothing to something will make a difference in terms of overall GDP growth next year.

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