Brian Fallow: Reserve Bank's hopes of soft landing for the economy will be hard to pull off

Central bank sees GDP growth continuing, but that forecast could easily veer off course. Photo / 123RF

OPINION:

It is going to be hard for the Reserve Bank to pull off the soft landing for the economy that it forecasts, as opposed to the undercarriage-buckling kind, when the crosswinds of uncertainty are so strong.

The latest monetary policy statement released on Wednesday forecasts gross domestic product growth to slow from 5.3 per cent in the March 2022 year to 2.9 per cent in the coming year and a still-positive 1.5 per cent in 2024/25.

It expects inflation to slow from 6.6 per cent right now to be back within its 1 to 3 per cent target band by the middle of next year, and back to the mid-point of 2 per cent by 2025.

That would be aided by the unemployment rate rising fairly gradually from an unsustainable 3.2 per cent now to be back above 4 per cent in three years' time.

If those forecasts pan out, governor Adrian Orr and the rest of the monetary policy committee (MPC) would be entitled to take a bow.

But the Reserve Bank's latest forecast for annual inflation in the quarter we are now in, is nearly a full percentage point higher than its pick just three months ago.

And it is now pencilling in another 75 basis points of official cash rate rises, over and above its projection last November, over the next couple of years, to a level 2.25-2.5 percentage points higher than it is now.

It goes to show how brittle forecasts are in these times of peril and pestilence.

The Omicron variant had barely been identified when the November statement was written. Omicron's impact on consumer sentiment and spending on the demand side, and the disruptive effects of large numbers of people off work sick or isolating on the supply side, and how long those effects last, are all significant sources of uncertainty.

The bank acknowledges that Omicron will weigh on confidence and output. But citing international experience, it expects the increase in absenteeism to be sharp but relatively short-lived.

"Given recent difficulties in finding labour, businesses are expected to smooth through any near-term weakness in demand by cutting hours rather than employment. However, there are risks to both sides of this assumption," it says.

Another key source of uncertainty around the pace of tightening is how households and businesses respond to higher interest rates.

"While higher interest rates are necessary, households and firms may have become more sensitive to interest rate changes as their debt levels have risen," the MPC said.

They also point to the "significant proportion" of mortgages which will be reset at a higher interest rate this year. The ANZ says 71 per cent of mortgages are either floating or fixed for less than one year.

Another channel through which higher interest rates will suck demand out of the economy is through their effect on house prices and the wealth effect. The Reserve Bank estimates households consume 2c or 3c in every additional dollar of household wealth, even if they have to borrow to do so.

That might not sound like much but we have just seen, in the year to September, households' collective net worth increase by nigh on half a trillion dollars. The potential reversal of that effect as house prices fall will leave a conspicuous hole in consumer demand.

Reserve Bank governor Adrian Orr. Photo / Mark Mitchell

The bank is forecasting house prices to fall 5 per cent this year and a further 4 per cent by mid-2024, though Orr said they were more confident of the direction than the magnitude.

Nor can we forget the ever-present ability of the other 99.8 per cent of the word to make life difficult. Front of mind there would have to be the Ukrainian crisis and the risk it poses, for example, to oil prices.

Not only that. "Associated economic sanctions would likely dampen global activity and may lead to further disruptions to supply chains. This could further weigh on risk assets and tighten global financial conditions," the bank says.

As it is, it assumes tighter monetary policy in some of New Zealand's key trading partners will place continuing downward pressure on the kiwi dollar, increasing domestic inflationary pressures.

It expects wage inflation in the private sector to accelerate further, peaking at 3.7 per cent (from 2.8 per cent now) at the beginning of next year, reflecting increases in the minimum wage, the tight labour market and rising living costs.

A troubling assumption the bank is making is that the "structural" level of unemployment remains high compared with pre-Covid levels, reflecting a mismatch of skills in the labour market exacerbated by border restrictions.

As those restrictions ease, rather gingerly, over 2022 it expects net migration of working-age people to pick up from essentially zero now to a long-run average of around 24,000 a year.

But that will depend on the extent to which New Zealanders resume their normal net outflow, to join the ranks of the Kiwi diaspora, once the risk of being stranded overseas is removed.

The net effect of migration on the labour supply, on one side of the inflation scales, and on population growth and aggregate demand on the other is another key area of uncertainty.

Overall, the statement is hawkish. But it is but not the fearsome Haast's eagle outlook that might have been on the cards given the strength of the most recent data on inflation and the labour market.

What may have kept the bank from a more aggressive tightening stance is inflation expectations.

Increases in expected inflation can put downward pressure on the real interest rates that households, businesses and investors perceive they face, once they adjust for their own expectations of inflation.

Right now, unquestionably, real interest rates need to rise.

Short-term inflation expectations, which are influenced by the latest inflation out-turns and which impact current wage- and price-setting behaviour, have jumped over the last six months.

But what the Reserve Bank worries most about is longer-term expectations, which reflect its credibility and therefore effectiveness as an inflation-targeter.

"The much smaller movement in longer-term expectations is consistent with inflation expectations remaining anchored at the MPC's target. That is, the perception that the Reserve Bank's outlook for higher interest rates will see capacity pressures ease and inflation decline in the medium term."

But it acknowledges the risk that persistently high inflation will lead to a change in wage- and price-setting behaviour, that would require even tighter monetary policy.