Justification for keeping interest rates low becoming harder to swallow

A surge in March quarter GDP is further evidence of a resilient New Zealand economy. But with economic activity comfortably above pre-COVID levels, employment rising, and inflation also set to pop higher, it’s becoming harder to justify keeping interest rates at record lows.

Summer spend-up keeps the economy moving

March 2021 data showed GDP up 1.6% (seasonally adjusted) from the December 2020 quarter – much stronger than economists’ expectations of 0.5-0.8% growth. The result meant economic activity was sitting 0.8% above December 2019’s pre-pandemic levels, even though the March quarter was expected to be most affected by the loss of international tourist spending during the usually peak summer months.

Instead, locals flashed the cash and kept businesses ticking over. Household spending rocketed up 5.4% (seasonally adjusted) from December 2020. This result was an incredibly strong one, dwarfing the previous largest quarterly increase of 3.5% (ex-lockdown) recorded in 1988. On a seasonally adjusted basis, private consumption was 6.4% higher than the last pre-COVID quarter at the end of 2019 (see Chart 1).

Spending results since March suggest continued vigour in consumer appetites. MBIE electronic card data shows average growth in domestic spending in the June quarter to date is up 5.3% from 2019 levels, which is even better than the average of 3.7% growth recorded during the March quarter. With options and appetite for overseas travel still very limited, it’s expected that New Zealanders will continue spending locally.

A tighter, and swiftly recovering, labour market will help keep economic momentum upbeat. The unemployment rate has dipped from 5.2% in September 2020 to 4.7% by March this year, and monthly filled jobs are continuing to show rising employment. Job ad numbers are higher too, adding to the weight of evidence of a solid economic recovery.

Supply issues could still limit the speed of recovery

We remain concerned about the potential for the economic recovery to hit a ceiling as supply chain issues and capacity constraints continue to bite. These concerns are widespread and rising. Shipping issues continue to hit imports and exports, with it remaining difficult to source various products and inputs, as well as taking longer and costing more to get available goods into New Zealand.

Just as worrying is the difficulty in getting New Zealand exports out of the country, which could limit export income. Total exports fell 8.0% (seasonally adjusted) in the March 2021 GDP data and, even once service exports (tourism and education) are accounted for, there was still a 1.5% fall in goods exports. In other words, the March quarter GDP result could have been even more impressive if exports had kept pace.

Skills shortages are continuing to be felt across a swathe of sectors, which will keep some areas from expanding further, and delay some projects. Higher energy prices are also constraining activity at major manufacturing facilities, and constrained hydro and gas generation capacity is not expected to improve any time soon, judging by continued high futures pricing for electricity.

So even though strong demand across the economy is expected to hold up, New Zealand’s ability to deliver and supply what consumers and businesses want is being called into question.

Low interest rates have worked, so are they still needed?

As COVID-19 hit New Zealand and the world, the Reserve Bank slashed the official cash rate (OCR) to 0.25%, started a massive bond-buying programme, and eventually provided a cheap lending programme directly to retail banks. All these actions were designed to drive down the cost of borrowing, reduce the benefit of saving, and boost (or at least limit the fall in) spending and investment.

Spending activity, as outlined above, is in a healthy position. And business investment is starting to get going again, with an 8.8% (seasonally adjusted) expansion in March 2021. Inflation is also expected to rise – temporarily in the short term as supply chain issues bite. However, there are rising concerns that these stronger demand conditions will result in higher trend inflation ahead.

The Reserve Bank has recently stated that the next change in monetary policy will be a move in the OCR, rather than any big changes to its Large Scale Asset Purchases or Funding for Lending Programme. The Bank will still be wary of moving too early and kneecapping the economic recovery. But with house price inflation continuing to reach new record highs, there’s increased pressure for tighter monetary conditions to try and take some heat out of the housing market.

The risks to our previous OCR forecasts are clearly to the upside and we are actively reviewing our projections. We are likely to bring our forecast of the next OCR change forward from late 2022 (which is already earlier than the timeline we published in April) to the first half of next year.

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