Surviving the Bears: Recession will be hard to avoid amid inflation fight

Reserve Bank Governor Adrian Orr. Photo / Mark Mitchell

When a central bank uses terms like "resolute" and "briskly" to describe its approach to getting inflation under control it behoves market participants to pay attention and to listen to what the bank is saying.

The Reserve Bank of New Zealand (RBNZ) signalled very clearly in April that interest rates were going to move higher and that the market should prepare itself for a swift upward adjustment to the Official Cash Rate (OCR).

Despite the wobbles in global equity markets and the rather half-hearted interest rate responses being delivered by all the major foreign central banks, the Reserve Bank ploughed ahead with its interest rate increases, delivering a further 50 basis points (bp) rate rise in May.

The bank's May Monetary Policy Statement (MPS) made clear that falling house prices and falling equity markets don't matter in the face of generational highs in inflation, and a record low rate of unemployment.

The hawks are necessarily back in charge at the Reserve Bank, though the economic data in recent months would suggest that their return was some months later than would have been optimal.

Having already pushed the OCR up to 2 per cent the Reserve Bank is almost certain to deliver another 50bp rate hike in July with an additional 50bp increase to follow in August.

The cash rate started this year at 0.75 per cent. By the end of the year the financial market thinks it will be at 4.25 per cent.

The peak in the OCR early next year is now expected to be at 4.60 per cent.

The MPS inclusion of the terms "resolute" and "briskly" would have been carefully considered.

These are deliberate and purposeful comments, and the market has heard the bank's message loud and clear.

The interest rate curve now prices in more rate increases than the Reserve Bank itself projected in its May statement.

In his time in charge of the Reserve Bank, Governor Adrian Orr has had some testy exchanges with journalists and commentators who have questioned the central bank's approach to bank capital, negative interest rates and its expanded focus on climate change and the Māori economy.

He has delivered fewer speeches on traditional monetary policy and the economy than most of his predecessors in the Governor's role, and he has made it quite clear that his vision for the Reserve Bank is quite different from what went before.

Change is apparent everywhere from the front lobby of the Reserve Bank building at No 2 The Terrace, to the look and feel of the central bank's major policy releases and on to the senior staff and Monetary Policy Committee members.

Almost every senior member of the policy team has changed under Governor Orr's watch.

Despite those past issues, the Governor is now savouring the acclaim that the Reserve Bank is being accorded for having started raising the OCR in October of last year.

That decision now appears far-sighted compared with his slower-moving global central banking colleagues. The fact that the Reserve Bank should have been raising the OCR even earlier than October has been forgotten against the backdrop of near-daily central bank rate increases all around the world as the United States Federal Reserve, the Bank of England, the Bank of Canada, the Reserve Bank of Australia and even the Swiss National Bank are all playing policy catch-up.

All of them now realise that the inflation genie is out of the bottle, and the academic argument about whether inflation is transient or persistent has been settled in a dramatic explosion of global price pressures.

In a league full of terribly weak performances the Reserve Bank has been the best of the central bank bunch, and for that the Governor and his team deserve some praise.

At the time of his appointment there was some expectation that the new Governor would do things differently and that he would discard the old automatic policy responses which discharged the full battery of interest rate artillery as soon as inflation was spotted anywhere on the distant horizon.

All of the bank's previous Governors earned their hawkish reputations due to their uncompromising approaches to controlling inflation.

After some early wobbles and a dangerous dance with negative interest rate policy back in 2020, Governor Orr's inner raptor has now been discovered and his talons are now clearly visible.

The market is now in no doubt that the Governor is firmly focused on achieving the Reserve Bank's mandated 1-3 per cent inflation target.

Prevailing economic conditions in New Zealand leave the country better placed to cope with higher interest rates than is usually the case when a hiking cycle begins.

The country's unemployment rate is sitting at an all-time low of 3.2 per cent, interest rates are still well below their historical average and thanks to various Reserve Bank's and government pandemic initiatives there is a huge amount of excess liquidity in the banking system.

Over the past 30 years Reserve Bank Governors have struggled with the fact that as they have raised interest rates to constrain inflation the New Zealand dollar (NZD) has also risen.

Former Governors Alan Bollard and Graeme Wheeler both found that their ability to continue raising rates was constrained by the strength of the dollar and the negative impact that it had on key export industries such as dairy.

One of the welcome surprises in the current cycle is that the NZD has traded softly for much of this year, despite the Reserve Bank being the first central bank cab off the rate-tightening rank and dairy prices trading at record highs.

That lack of currency constraint means that the MPC can largely ignore the currency as a factor in their immediate deliberations.

The MPC's decision making will not be constrained by FX worries or concerns about the rural economy.

This means that there is absolutely no reason to doubt the bank's rate tightening resolve at this time, or to assume that the speed of the policy adjustment will be anything but brisk.

Interest rates will continue to move higher as the year goes on and the Reserve Bank will look for signs of economic pain and moderation as indicators that its policy adjustment is having the desired effect on inflation.

The Governor has made clear that he believes that there is an excess of demand in the economy which is being exacerbated by global supply chain constraints, and by China's ongoing lockdowns and port closures each time it detects a few new cases of the virus.

Until supply chains normalise the excess of consumer and business demand over supply will remain, and until New Zealand's borders properly reopen the excess of labour demand over the supply of available workers will continue to support consumption.

Until these conditions normalise the Reserve Bank will continue to push interest rates higher, until the inevitable slowdown — and probable recession — occur.

While no central banker will ever say so openly, it remains the case that a rise in the level of unemployment alongside ongoing downward pressure on house prices are necessary pre-conditions for a reduction in demand and inflation pressures.

Governor Orr and his Monetary Policy Committee will certainly hope to avoid that outcome — but it will be extraordinarily difficult to do so.

The Reserve Bank was the first central bank to begin the current interest rate tightening cycle.

Given their resolute inflation focus it will be very hard for them to avoid also becoming the first to push their economy into a recession.

- Sean Keane is the founder and managing director of Triple T Consulting.