- The Reserve Bank of New Zealand (RBNZ) surprised many at its November Monetary Policy Statement (MPS) with a more hawkish view of recent economic developments. While we don’t necessarily view the skew in economic risks the same way, we recognise the high degree of uncertainty in the economic outlook and the importance of understanding the central bank’s point of view.
- At the heart of the RBNZ’s hawkish shift are two factors: higher-than-expected rates of migration and the related fact that non-tradable inflation remains well above a comfort zone.
- Much of the RBNZ’s more hawkish view fits our upside interest rate scenario, which we are now more respectful of after the November MPS. Combined with the substantial drop in interest rates over the past two months, we have reduced duration significantly in fixed income portfolios such that they are only modestly longer than benchmark.
Socrates once said, “one thing only I know, and that is that I know nothing”. That’s a bit like how we felt digesting the RBNZ’s latest MPS. The central bank lifted its Official Cash Rate (OCR) path to imply an 80% chance of another hike next year. It also dropped its prior forecast of recession for the second half of 2023, lowered its unemployment rate forecast, and added further to expected house price gains. These changes were made in the context of almost all the economic data in recent months suggesting that monetary policy is working better at reducing inflation and dampening economic demand than was anticipated at the last MPS in August.
At the heart of the RBNZ’s hawkish shift are two factors: higher-than-expected rates of migration and the related fact that non-tradable inflation remains well above a comfort zone. We explore each of these below. Another factor in the more hawkish stance is an assumption of higher government investment spending based on the September Pre-election Economic and Fiscal Update (PREFU). We have chosen not to explore that further here given the new National-ACT-New Zealand First government will provide a formal update on its fiscal plans on 20 December as part of the Half Year Economic and Fiscal Update (HYEFU). The RBNZ also lifted its long-term estimate of the neutral OCR from 2.25% to 2.5% due to higher long-term market interest rates but this had little impact on the near-term OCR forecasts.
Migration may be becoming net inflationary
The 120,000 migrants that have entered New Zealand over the past year represent 40,000 more than the RBNZ anticipated in its August MPS forecasts. While the RBNZ acknowledges the helpful reduction in labour market pressures due to migration, it is now more concerned about the impact on demand. It cited the Q2 upside GDP surprise, upward pressure on rents and recent house price gains as evidence of this. Population growth has surged to a record high of 2.7% y/y and suggests meaningful demand for housing services, whether that be renting or buying. This rate of population growth also suggests pressure on council rates, that make up 3% of the CPI, as local authorities look to increase infrastructure capacity. Councils are already facing immense demands on infrastructure replenishment, with some councils already indicating that huge increases in rates are likely for the 2024/25 fiscal year. Insurance costs, which have also surged over recent years appear likely to rise sharply again.
Rents, which make up 10% of the CPI, have been running at 4.5% y/y - about double the pre-COVID average. New rents have been growing even faster at 6% y/y and wage growth hasn’t yet slowed sufficiently to suggest this rate of increase is going to drop a lot any time soon.
Source: Stats NZ, Macrobond
The RBNZ forecasts house prices to increase 5% next year. Our house price model, which includes population growth, mortgage rates and the unemployment rate, suggests this could be even higher (for details of the model see How vulnerable is our housing market? 17 March 2020). Higher house prices may slow the decline in residential investment and the rate of construction cost (9% of CPI) disinflation. Higher house prices are also likely to support consumption, all else equal. For example, RBNZ research in 2019 on the housing wealth effect suggested that for every $1 increase in house prices, households increase consumption by 2 cents.1 House price declines are estimated to have a larger impact, with consumption dropping 3 cents for every $1 decrease in house prices. For reference, estimates for the US housing wealth effect are around 4 cents.2
Source: Stats NZ, REINZ, Macrobond
Poor housing affordability, however, is likely to limit house price gains and our model doesn’t capture that. We estimate house price-to-income ratios are around 10 times, versus 6 in the early 2000’s, and new buyers need almost 70% of household disposable income to service an average mortgage. The expected hikes in council rates and insurance will also reduce housing affordability. It’s a mixed bag for property investors. The new Government’s re-introduction of interest deductibility and a reduction in the bright line term for tax on capital gains are unambiguously positive. Current rental yields, however, are close to historic lows.
Inflation is not falling quickly enough
The RBNZ’s tolerance for inflation above the 1% to 3% band has reduced, particularly with non-tradable inflation still running at 1.7% q/q (or 1.4% q/q when seasonally adjusted) and 6.3% y/y. The central bank wants to see more progress than it did in August and seems frustrated that inflation expectations are not sufficiently close to the mid-point of the 1-3% target band. This focus is likely to strengthen when the new Government changes the Policy Targets Agreement (PTA) to make inflation the sole objective of monetary policy.
Source: Stats NZ, Macrobond
Unexpectedly high rates of migration are a key contributor to the RBNZ’s sensitivity to high inflation. Housing costs make up almost 30% of CPI and almost half of non-tradable inflation. Should the rates of migration not ease as the RBNZ forecasts, to 50,000 per annum by the end of next year, pressure on rents and house prices is likely to be more persistent. This is likely to require greater disinflationary forces elsewhere and/or a tighter monetary policy stance. Given the connection between net migration, infrastructure requirements, housing costs and inflation, it may be time for the Government to have a more considered and explicit policy approach to immigration.
Note: Dotted line is RBNZ forecast. Source: RBNZ, Macrobond
Much of the RBNZ’s more hawkish view fits our upside interest rate scenario which we are now more respectful of after the November MPS. Combined with the substantial drop in interest rates over the past two months, we have reduced duration significantly in fixed income portfolios such that they are only modestly longer than benchmark. We still think more cuts can be priced for next year, and the market-implied trough for the OCR is too high at 4%, but the market better reflects the balance of risks, in our view. Things to watch from here include Q3 GDP on 14 December, the new Government’s HYEFU on 20 December, CPI on 24 January and labour market data on 7 February, before the next RBNZ meeting on 28 February.
References:
1See de Roiste, M, Fasianos, A., Kirkby, R. and Yao, F. (2019) “Household Leverage and Asymmetric Housing Wealth Effects – Evidence from New Zealand” DP 2019/01
2See Caceres, C. (2019) “IMF Working Paper: Analyzing the Effects of Financial and Housing Wealth on Consumption using Micro Data” WP/19/115
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