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Will the New Zealand economy tip into recession?

  • EIU believes that the Reserve Bank of New Zealand (RBNZ, the central bank) will continue to raise interest rates to bring down the very high rate of consumer price inflation.
  • Our central scenario assumes that the RBNZ will lift its policy rate to a peak of 4% by the end of 2022, which would leave the economy flirting with recession in 2022‑23. We believe that it will avoid two consecutive quarters of contraction, but growth will be below long-term averages. 
  • We also offer two other indicative scenarios: in the first, the RNBZ ends monetary tightening prematurely, resulting in another surge in inflation in mid‑2023; in the second, it pushes the policy rate above 4% and the economy tips into recession in the first half of next year.

The RBNZ has led the charge among central banks in advanced economies to remove the emergency stimulus put in place in early 2020 during the acute phase of the coronavirus pandemic. It first raised the official cash rate (OCR) in October 2021 and has since added 225 basis points, taking it to 2.5% as at early August. This is partly because the local economy endured a shorter and shallower contraction during the pandemic and partly because government job-protection programmes insulated the labour market, ensuring that unemployment remained relatively low.

The economy’s resilience and vibrancy after the worst of the pandemic meant that the RBNZ was confronted with inflation caused by both supply-push and demand-pull factors—hence the aggressive lifting of interest rates. However, we believe that the central bank still has further to go.

Consumer price inflation in the second quarter of 2022 accelerated to a new recent high in year-on-year terms; on a quarterly basis it remained above 1.5% for a fourth consecutive quarter. In its most recent monetary policy statement, the RBNZ described itself as “resolute” in its desire to bring down “pervasive” inflation through raising interest rates “briskly”. It noted the growing risk of a big hit to economic growth as a result of lifting the OCR above neutral, but gave the impression that it considered allowing inflationary expectations to become entrenched at a high level to be a bigger threat.

Central scenario: higher rates finally pass through to domestic demand

Based on an assumption that the RBNZ will add a further 150 basis points to the OCR by end‑2022, our central scenario assumes that economic growth will slow to a trickle in the second half of 2022 and early 2023. The main avenue through which this will be evident is household spending, which accounts for around 60% of GDP. Higher mortgage and loan repayment costs, combined with continued increases in food and fuel costs, will inhibit more discretionary spending.

It is possible that this transmission may be a little slower than in previous periods of tightening monetary policy, because of the savings built up by New Zealanders during lockdowns. We also note that the pandemic-induced volatility in year-on-year data will also continue to make the interpretation of national-accounts data more difficult than usual.

For example, we expect private consumption to contract on a quarterly basis in October-December 2022, but the low base in both the third and fourth quarters of 2021 means that it is likely to grow by around 4% in year-on-year terms. Here, the quarterly figure will be more indicative of the actual state of domestic demand. Growth in consumer spending, business investment and residential construction is likely to slow to a trickle, with momentum likely to be supported only by government outlays and the return of foreign tourism exports.

Crucially, we believe that an OCR of 4% would weaken domestic demand sufficiently for overall inflation to begin to slow, to the degree that it would fall back within the RBNZ’s target band of 1‑3% in the second half of 2023. With the central bank believing that an OCR of 4% constituted an above-neutral rate, we believe that it would look to reduce its policy rate at the earliest possible opportunity, which is likely to be around the midpoint of next year. On the assumption that there are no further external inflationary shocks, we believe that it would continue to relax policy slowly until late 2024, by which point the OCR would be at the broadly neutral rate of 2.5%. 

Downside scenario: RBNZ maintains hawkish stance, economy tips into recession

Beyond our central scenario, we believe that the next most likely outcome is that the RBNZ veers on the hawkish side and continues to raise the OCR aggressively in the first half of 2023, pushing it up to 5% or higher. The spur to do this could come from the labour market. Wage growth has begun to rise very quickly, which suggests that inflationary expectations are becoming entrenched—a situation that the central bank will be very keen to avoid. If it continues to push up interest rates to break inflation, it would result in a bigger hit to GDP, house prices, the construction industry and business investment. 

In this scenario, the positive contribution from tourism and education exports would not be sufficient to offset the decline in consumption, resulting in a recession. It is possible that this scenario could come to pass if there was another external inflationary shock, such as climate-induced crop failure in late 2022 that pushed global food prices even higher, as domestic demand would have to be forced even lower to bring inflation back down to the RBNZ’s target rage. In this scenario, it would take longer for the central bank to begin returning the OCR to neutral.

Upside scenario: RBNZ ends monetary tightening prematurely

Another alternative scenario could see the RBNZ spooked by the threat of a recession, resulting in it leaving the OCR at a lower level, such as 3.25%. Although this would be positive for growth in the short term, we believe that it would leave the economy vulnerable to a prolonged period of high inflation and the continuation of a wage-price spiral. We know that at least part of the reason for the ongoing surge in inflation is a lack of capacity in the domestic economy, given the very low unemployment rate. If the central bank walked away from its previous commitment to raising interest rates until inflation falls, it would risk some reputational damage, as well as a more serious stalling of economic growth once high inflation and high wages begin to cause some firms to go under. 

We remain fairly confident in our central scenario, to which we would assign a probability of around 60%. Our second scenario, of the RBNZ pushing interest rates up to around 5%, is the next most likely, with a probability of around 30%. We believe that the risk of the central bank reneging on its current promise and the OCR peaking at below 4% is low, at around 10%. However, we also note that as a small, open economy, New Zealand remains exposed to abrupt changes of sentiment elsewhere, and the external picture could look very different by the end of 2022 than it does at present, depending particularly on global prices for agricultural goods and fuel. 

The analysis and forecasts featured in this piece can be found in EIU Viewpoint, our new country analysis solution. EIU Viewpoint provides unmatched global insights covering the political and economic outlook for nearly 200 countries, helping organisations identify prospective opportunities and potential risks.