This opinion piece was first published on Stuff on 26 February 2024.

All eyes are on the Reserve Bank this week, with a few different guesses over what they’ll say and do. The variety of opinions reflects a lot of twists and turns in the last couple of months. Financial markets got excited about the possibility of impending interest rate cuts late last year after weaker GDP data emerged. Wholesale swap rates, which feed into the pricing of fixed mortgages, plunged as much as 1.3 percentage points, and forecasters brought forward their expected timing for the first reduction in the official cash rate. But over the last month, markets have reversed more than half the decline in wholesale rates we had previously seen.

What’s going on? These sorts of swings are typical of the market when the economy is near a turning point. Depending on how you read the tea leaves, there is evidence backing up the Reserve Bank’s hawkish stance, but there is also evidence suggesting the Bank has done enough tightening. Although our view now leans towards the latter, it’s worthwhile examining both sides of the interest rate argument.

Inflation is easing faster than expected. Just six months ago, the Reserve Bank forecast that inflation at the end of 2023 would be 5.2%pa, but it has slowed to 4.7%pa. Having severely undercooked its inflation forecasts since mid-2020, the Bank is now overcooking them, as tighter monetary policy around the world squeezes pricing pressures out of the system.

Related to the slowdown in inflation is weaker-than-expected economic growth. Wholesale interest rates fell markedly in December following the release of new GDP data, which included a 0.3% fall in September’s quarterly activity as well as downward revisions to growth estimates throughout the previous nine months. Declining activity theoretically equates to more spare capacity, as opposed to the strong growth and highly stretched economy that prevailed throughout 2021 and 2022.

Not only has the economy been shrinking, but its capacity is also being rapidly boosted by record-high net migration. The 255,000 permanent arrivals into New Zealand during 2023 was 76% above 2016’s pre-pandemic peak. Businesses are finding it much easier to recruit the staff and obtain the skills they need, reducing the critical labour cost pressures that were fuelled by headhunting and staff poaching over the previous couple of years.

Amid these trends, we note that the squeeze on household budgets from higher mortgage rates has not yet fully run its course. The average interest rate being paid across all mortgage debt has lifted from 2.8% in September 2021 to an estimated 5.9% currently, and it will push up towards 6.3% over the next six months as homeowners continue to roll off lower fixed rates from two or three years ago. The additional pressure on household spending during 2024 will be nowhere near as critical as it was in 2022 and 2023, but genuine relief from much higher mortgage payments is some time off yet.

Each of the above points has a valid counterargument for why the Reserve Bank might still be leaning towards further interest rate increases.

Domestic inflation has not eased anywhere near as much as headline inflation over the last nine months, and this inflation component is the one the Reserve Bank has the most influence over. The Bank is worried that persistent domestic inflation could prevent inflation back from getting back inside the 1-3%pa target band as quickly as it would like.

The Bank has also downplayed the weaker GDP figures, in part because the data has not fundamentally altered its estimates of how much spare capacity the economy has. Alongside this conservative view, the Bank has also expressed concern about the migrant influx boosting demand across the economy, offsetting the positive supply effects associated with the greater availability of workers. To date, there have been some examples of these demand pressures coming through in rental and house price inflation.

Despite the unemployment rate’s lift from 3.4% to 4.0% since March last year, businesses are still employing more workers, and wage inflation remains considerably elevated, at 7.0%pa. The failure of this indicator to slow ties into the Reserve Bank’s concerns about domestic cost and price pressures. But it could simply be a matter of timing – when the economy turns, the labour market is usually the last thing to turn, and wages are one of the most lagging indicators of all. Furthermore, closer inspection of the data suggests that private sector labour cost growth is easing, but the overall numbers are being kept higher by large public sector collective agreements that came into force in the latter part of 2023.

The Bank also runs the risk that a dovish interpretation by financial markets of this week’s statement could lead to lower retail mortgage rates, representing an effective easing in monetary conditions sooner than the Bank would like. This possibility provides grounds for the Reserve Bank to maintain a tough line on the interest rate outlook. The difficulty for the Bank is that it might find its credibility stretched if the tough talk isn’t accompanied by a rate hike, given that its November forecasts had already suggested another increase was more likely than not.

In our view, the Reserve Bank has already done enough to bring inflation under control. At the same time, our concern is that the Reserve Bank’s statements over the last 2½ years are littered with a lack of foresight, with interest rate decisions often reacting to trends that were more relevant six months previously. In 2021 we pushed for earlier and sharper interest rate increases to ward off higher inflation, which were ignored. In earlier 2023, we raised concerns around migration’s risk to inflation, but the Bank viewed these effects as uncertain. Then in November, they caught up to the rest of us by warning about the demand-driven inflation pressures that migration could bring.

This week, the Reserve Bank could continue to get sidetracked by worries about immigration demand pressures and last year’s wage increases, rather than looking forward at the likely outcomes for 2024 that suggest its job is already done. We’re not arguing that the economy suddenly needs a whole lot more stimulus – far from it. However, pulling the interest rate trigger once or twice more is unnecessary given the full effects of the rate rises in the first half of 2023 have yet to work their way through the economy.

It's not yet time to move the foot from the brake to the accelerator. But, equally, the economy is already slowing down, and there’s no need to pull the handbrake up too.