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State of the Nation

State of the Nation

Top economist Cameron Bagrie takes deep dive into the country’s economy.

26 June 2024

More pain and patience, that’s what’s required before interest rates come down.

Interest rates might have to rise further to tame the inflationary beast. The Reserve Bank discussed raising the Official Cash Rate (OCR), not cutting it in the May Monetary Policy Statement.

The neutral OCR – where the Reserve Bank (RBNZ) neither has the foot on the accelerator or the brake – was raised again to 2.75 per cent. The trend is north and that will guide where the OCR could eventually fall too. I suspect it’s headed to 3.5-4 per cent.

Interest rate relief is looking a 2025 story, although some economists continue to say late 2024. The RBNZ’s forecasts say mid-2025. Not exactly news a property investor was hoping for, but it’s the reality we must deal with and understand.

Bad news, positive omens

The culprit is inflation, which is proving to be stubborn and sticky. Non-tradable inflation is currently 5.8 per cent; the RBNZ was forecasting 5.3 per cent. This upside surprise was broad-based across non-tradables inflation components.

What saved us from higher interest rates was a weaker economy. In fact, the economy right now argues for lower rates in 2024. Bad economic news has positive omens.

The stars are coming into alignment for inflation to recede. The economy is being progressively beaten up. Tough times mean price increases are harder to pass on; firms start to discount when the volume of work shrinks; consumers push back on price increases and shop around.

Look no further that concrete production as an indicator. It’s down 12 per cent on a year ago. Fewer concrete slabs lead to less construction work.

Inflation struggle

We face challenges getting inflation to two per cent, which is the target.

The RBNZ has consistently under-estimated non-tradable inflation pressure over the past year despite a weakening economy. Weak demand says non-tradable inflation should turn lower, but the key word here is should. The RBNZ is going to want to see it. That is far from ideal as by the time they react it could be too late but necessitated by having misjudged its strength.

Getting inflation to two per cent is not being helped by persistent inflation from segments including rents, insurance costs, council rates, energy prices and local airfares. Local authority rates, for example, look set to rise 15 per cent in the September quarter 2025.

Persistent and stubborn price increases carry the risk that stronger prices become the norm and settle in price and wage setting behaviour.

We have an economy that has been beaten up, not just through a demand lens or suffering from higher interest rates. It has suffered structural damage making it less efficient and effective. Just look at the roading network; a less effective network hampers productivity and adds to costs and inflation.

The OECD’s recent economic survey on NZ noted that “Declining school education performance and ongoing inequity are a serious threat to New Zealand’s prosperity” and that “the decline of almost 29 points in New Zealand’s average PISA score between 2006 and 2018 will eventually reduce aggregate productivity by close to four percentage points.”

The bottom line

Inflation pressure alone said the RBNZ needed to hike, and they considered it. The economy says they need to cut soon; they didn’t consider that.

Their projections imply a 60 per cent chance of a hike with a 5.65 per cent OCR projection when the OCR is currently 5.5 per cent. That’s a hat-tip to the risk if we get another bad inflation read and continued persistent inflation vibes.

The RBNZ and economy is facing the difficult stage of the cycle, where real economic pain is inflicted to drive the disinflation process.

It’s the tough stage. If you fold too early, inflation could reignite, presenting a bigger problem and require even higher interest rates. Being too tough and keeping rates too high for too long could lead to excessive economic harm and sharp rises in unemployment. Who would want to be a central banker?

The views expressed in this article do not represent financial advice.

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