By Bevan Graham
The New Zealand economy is recovering well. Activity indicators continue to surprise on the upside, the unemployment rate is nearly back to pre-COVID levels, and forward indicators of inflation are all pointing towards higher inflation ahead.
It should not have come as too much of a shock that once the Reserve Bank of New Zealand reintroduced a projected track for the Official Cash Rate (OCR), after having dispensed with it during the uncertain COVID times, that track would point to higher interest rates ahead.
The Bank did not disappoint with its May Monetary Policy Statement (MPS) last week. In reintroducing projections for the OCR the Bank indicated “lift off” in the tightening cycle was likely from around the second or third quarter of next year. That is in line with current market pricing and our own interest rate forecasts.
One can only surmise how that track might have differed from projections that would have been provided during the track-less interregnum, especially given much of the RBNZ’s forecast outlook for GDP growth and inflation is largely unchanged from their February view.
The key thing that has changed is the recent performance of, and outlook for, the labour market.
In February the Bank was expecting an unemployment rate of 5.0% in the March 2021 quarter, which came in at a significantly better 4.7%. Looking further out, the February MPS had the unemployment rate staying around 5% for a couple of years before dipping under 5% towards the end of the projection period. In the May MPS the Bank was now projecting the unemployment rate to decline to 4.3% by mid-2024.
Furthermore, the labour participation rate is recovering too, so labour that has been sitting on the sidelines during the recession is now back and at least looking for work. That’s great news.
We know the Bank thinks New Zealand’s non-accelerating inflation rate of unemployment (NAIRU) is around 4.5%. That means the unemployment rate is already close to and expected to soon move below that level with little left to draw from assuming the participation is headed back to pre-Covid levels.
We think the Bank’s views on the labour market outlook view err on the conservative. We have the unemployment rate falling faster, sooner.
From an activity perspective, the reality is that while many businesses reliant on foreign tourists will continue to struggle, domestic spending is doing a good of keeping activity more buoyant than expected.
March quarter retail spending was expected to show a contraction of 2% due to the lack of foreign tourists. Instead, sales rose 2.5%, suggesting some upside risk to the RBNZ’s forecasts of -0.6% for March quarter GDP.
Furthermore, the recent Budget was one of the more stimulatory in recent history – at a time when many firms are already experiencing labour shortages, the borders remain (mostly) closed and are likely to remain that way until well into next year.
The stimulus baton has been passed to fiscal policy, though we worry that the biggest risk to some of the Budget’s initiatives is there simply won’t be enough labour to do the work, putting upward pressure on wages and inflation.
There are two ways in which a labour shortage can be solved. The first is immigration, an avenue New Zealand has relied on for some time, though it has put other pressures on the economy including housing and infrastructure.
In the recent Budget the Treasury forecast net migration to rise back to around a net inflow of 45,000 per annum. At the same time however, the Government has recently announced an “immigration reset”. The announcement was light on detail, but will clearly have some impact.
The other release valve is productivity, something New Zealand has never been particularly good at. It is good news then that the Government has recently asked the Productivity Commission to have another look at this. It is, however, unlikely they will find any new answers. Education, skills, technology adaption and innovation are likely to still be the answers.
The Budget itself needs a lift in productive capacity of the economy. While some commentators applauded the Budget’s ability to significantly increase spending while at the same time generate a reduction in the debt profile, we need to look just a bit further back to pre-COVID times. The debt outlook is significantly higher.
Taking on more debt is fine if it is invested in generating higher sustained growth. Without that, higher operating deficits and debt levels get baked in, reducing capacity to respond to the next crisis.
So, the labour market seems to hold the key to a couple of important questions. Firstly, does it have the capacity to help deliver the Budget? And secondly, when will it be appropriate to start removing monetary stimulus?
While some of the higher inflation we are seeing now and expect to see over the next few months will be undoubtedly transitory, there are two indicators to keep an eye on right now to help answer that question: inflation expectations and wages.
The economy is in no-where near as bad a shape as it was predicted to be, yet monetary and fiscal policy are at the most stimulatory ever and the labour market is, by many measures, already tight.
That suggests to us it will be appropriate for the RBNZ to end its Large Scale Asset Purchase and Funding for Lending programs sooner rather than later. That would then set the scene for interest rate increases from the middle of next year.
Which raises another inevitable question: Can we go it alone in raising interest rates?
We have tried to raise interest rates out of step with the rest of the world before and it hasn’t ended well, particularly due to the resultant upward pressure on the New Zealand dollar, creating problems for the export sector.
But then we don’t think the US Federal Reserve will be far behind us. Aside from the durability of the current inflation spike, the Fed’s biggest problem is its employment mandate.
While the US labour market hasn’t recovered as quickly as expected, we think that is in large part due to labour supply issues and not just a shortage of demand.
While lower interest rates can help the labour market when the problem is a deficit of demand. Monetary policy is not as effective in solving labour market supply problems. The Fed may have to choose between its inflation and its employment mandate and start raising interest rates before the labour market is fully recovered.
The removal of monetary stimulus raises the risk of another QE taper tantrum as we saw in 2013. We think this time will be different. We expect a more mature approach this time, helped by the increase in market-based inflation expectations and the fact that the bond market will become more concerned with slow-moving central banks “accidentally-on-purpose” engendering an inflation overshoot, than with the risk of a premature tightening in policy snuffing out a fragile recovery, as has occurred in the past.
Furthermore, fiscal policy is far more stimulatory this time. Arguably, given the overwhelming scale of deficit spending at present, a small monetary tightening phase might not dent the recovery as much as it dents asset prices, where those assets have been buoyed up in recent years by super-easy money and mounting global excess liquidity.
Given the much higher debt levels around the world, interest rates will not have to increase as much during this next tightening cycle. That said, higher rates and the end of everlasting QE will have a negative impact on asset prices beyond bonds, including equity and housing markets.
In saying this, we cannot rule out the potential for some governments to attempt to manage and limit any negative asset market adjustments, to an extent that has become quite unfamiliar in recent decades. That would - or should - raise country risk premia for those sovereigns’ bonds and eventually undermine their currencies, too.
From a sectoral perspective rising bond yields keeps us wary on retirement villages and supports underweights to property and bond-like equities. We expect cyclicals to outperform GAAP (growth at any price) as the long-dated hoped-for earnings from companies with somewhat remote profitability will be discounted at a greater rate.
Overall, equities are a good hedge but history and academic studies suggests this changes if/when inflation persists for too long at above 3% as the discount rate effect dominates the higher top line earnings.