The cost of containing inflation

Closing out a turbulent year with the most significant rate rise to the Official Cash Rate (OCR) since the Reserve Bank of New Zealand (RBNZ) introduced the tool in 1999, New Zealand’s central bank chose shock and awe in the hopes of scaring inflation back into submission, says Cameron Bagrie, chief economist and managing director of Bagrie Economics.

With a long three months between November’s Monetary Policy Statement (MPS) and the RBNZ’s next meeting in February 2023, at the same time inflation runs rampantly high, employment is too strong, and expectations signal further financial pain, the central bank needed to do something drastic.

With the dust now settled on these recent decisions, positioned to gently nudge New Zealand into a voluntary recession, what does the road look like ahead?

HOUSING

New Zealand is entering into an over-building phase. However, the magnitude is somewhat unknown. So, while there are growing concerns that we’re becoming a townhouse nation in all the wrong places, I caution against over-zealous assessments and note policymakers will need to separate fact from fiction, Bagrie says.

Population growth used to be circa 90,000 per year, and at that level, you certainly need a lot of new homes to meet demand – upwards of 40,000 a year.

New Zealand has a long history of under-investment in housing. We have built too few homes for far too long while our population has skyrocketed. Despite playing catch-up, population figures have come off the boil, cooling demand and muddying the waters of projection.

According to Bagrie, supply in pockets of Auckland may now be exceeding demand, whereas the picture across other regions is more mixed. Housing shortages have transferred from main centres into more affordable areas driven by lifestyle preferences and an exodus of residents in search of value.

Housing remains a critical part of social infrastructure and requires long-term planning around projected population growth – not historical and not existing growth. But to do this, we need some certainty with migration policy, and in an election year, politics and the cost of containing inflation are on a collision course.

Housing remains a critical part of social infrastructure and requires long-term planning around projected population growth – not historical and not existing growth. But to do this, we need some certainty with migration policy, and in an election year, politics and the cost of containing inflation are on a collision course.

INFLATION

With a mandate to control inflation, Bagrie says the RBNZ has been backed into a corner and must keep dishing out the hits to re-establish its credibility.

“While a 75 basis point jump to the OCR surprised very few, given the jump in inflation expectations the real surprise was the OCR track, which indicated that the central bank now expects the OCR to peak at 5.5 percent around the middle of this year.

This is up from the 4.1 percent predicted at the MPS prior.

“Houston – we have a major problem,” Bagrie says.

Inflation expectations are at the epicentre of the central bank’s credibility in the battle against inflation, and the RBNZ’s two-year measure rose significantly, necessitating a further bludgeoning of the economy.

The RBNZ notes that demand across the economy has remained resilient to global and domestic challenges to date, with household spending staying elevated despite a fall in residential property prices, high consumer price inflation, and increasing mortgage lending rates.

While expectations for global economic growth have declined, and national house price indices have regressed to mid-2021 levels, residential values are still above estimates of sustainable house price measures and remain above elevated levels, which prevailed before the pandemic.

While expectations for global economic growth have declined, and national house price indices have regressed to mid-2021 levels, residential values are still above estimates of sustainable house price measures and remain above elevated levels, which prevailed before the pandemic.

Contributing to this, Bagrie says, is an extremely tight labour market with very strong wage gains adding pressure to inflation.

There are key drivers behind inflation, but the labour market is where we will see the most sensitivity and job losses are necessary if the RBNZ wants to get inflation under control.

We are well-beyond maximum sustainable employment, and unfortunately, to get inflation under control, unemployment must rise, but that will be a derivative of many other things such as less construction activity. This will impact Kiwis’ abilities to pay mortgages and could result in a greater proportion of distressed sales for the housing market.

Despite this, Bagrie doesn’t expect to see unemployment rocketing upward but rather a controlled effort to see demand return to equilibrium with supply.

Firms are going through their books with a fine-toothed comb right now, looking at profitability cost metrics. He says that financial officers will say, ‘look, it’s time to cut costs,’ and jobs are one lever a to achieve that.

It’s not just about sacrificing jobs to contain inflation, according to Bagrie. Many cycles will turn down – asset prices, spending, construction activity, profitability.

Containing inflation can be brutal when you’re staring at a seven percent figure, making efforts to hammer it down to two percent. Most of the population was not in the workforce the last time New Zealand faced a major inflation problem requiring heavy-handed monetary policy to put the inflationary thief back into jail.

POLITICS

Looming large on the 2023 horizon is New Zealand’s general election, scheduled for the latter half of the year. An event that Bagrie says will shape economic policy to year-end.

As the year unfolds, it has political interference written all over it. However, we don’t quite yet know the specifics of party policies.

Housing is always a pivotal issue, and given the challenges of the last 12 months, addressing cost of living will be high on the priority list, and he says, brace for the election year sweeteners.

The RBNZ has signalled an appetite for help in the battle against inflation. However, the Government is under pressure to provide key services, meaning they must spend more, adding to inflation.

Of the tax breaks suggested by various political parties, Bagrie says the more pressing issue is wage inflation driving Kiwis into higher tax brackets – or what he calls - tax thievery.

Real wages continue to rise, and the impact of this is that it moves ordinary Kiwis into higher tax brackets which have been found to net the Government an extra $500 million a year over a five-year timeframe. So, they’re about $2.5 billion better off just because they forced you into a higher tax bracket.

With the push-pull of economic policy creating unsteady ground for Kiwis in 2023, Bagrie says homeowners should keep a cool head, as we now face some payback after over-exuberance.

Accrued equity gains over the past decade put long-term asset owners in a preferable position to manage higher mortgage lending rates. So, while there are a set of grey economic projections as the cost of containing inflation is finally laid bare, Kiwis on balance, should be well-positioned to manage the effects of this projected recession and unemployment rising towards six percent.

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