Shredded-Money-2022
2022 in Review: The “I”s have it
Mon 19 Dec 2022 by Brad Olsen in Weekly commentary

A single letter of the alphabet seems to sum up 2022, with inflation, interest rates, and international events making for an intense economic year.

In this short review, we recap some of the key trends of 2022.

International events have geopolitics balancing on a knife edge

In our early February 2022 forecasts, we noted the risk of a war between Ukraine and Russia, stating that “supply concerns [are] likely to push oil prices up further” and that conflict would “dampen economic growth in Europe”. Weeks later, that conflict ignited, sending not only fuel prices higher, but also severely disrupting food-based production and exports, and sending Europe into an energy crisis that will tip the region into recession in 2023. We are understandably euphoric that our note around the risk of nuclear weapons use in our October 2022 forecasts has not come to pass, but the risk tone across Europe remains heightened.

Now formally next to Europe, rather than in it, the United Kingdom decided to test a different approach to inflation – one-up it. The Premiership of Liz Truss and her ill-fated economic ideas didn’t last long, but look set to prolong the UK’s economic pain, with high inflation and recession poised to hammer households next year.

The Chinese economy also remained an important economic area to watch. Economic growth slowed considerably in 2022 as the world’s second-largest economy stuck to a Zero-COVID strategy, hitting supply and demand globally. Recent protests have seen a swift change in fortunes, but with China having low vaccination rates, sickness and death is now spreading, adding further expectations of a limited recovery.

More broadly, the war for talent globally has seen a number of countries setting out targets for higher migration. Canada is now targeting around 1.4m migrants over the next three years, and Australia has increased their target by 35,000pa.

The above barely scratches the surface of the international developments in 2022, but highlights the ramifications that global events can, and did, have on New Zealand in 2022.

Inflation: persistent, pervasive, and very problematic

We’d pick “cost-of-living” as our word (phrase?) of the year in 2022. Inflation reached a current peak of 7.3%pa in the June 2022 quarter, before barely moderating in the September 2022 quarter to sit at 7.2%pa. Inflation has become persistent, pervasive, and incredibly problematic.

Pricing pressures have expanded considerably, with two-thirds of all items monitored rising in price in 2022, the highest in a decade. Key drivers of high inflation include food, fuel, building costs, and rent. Yet it’s less-recognisable price rises that cause almost greater concern, with increases in early childhood costs, local government rates, and two-minute noodles that suggests that prices have spiralled. Non-tradeable (domestically based) inflation is running at 6.6%pa, helping to attribute blame reinforce the importance of local action to tame high price rises.

As we see it, the challenge in 2022 is that the Reserve Bank has lost some of its inflation-fighting credibility. In May, Reserve Bank Governor Adrian Orr told Parliament’s Finance and Expenditure Committee to “step back and just breathe” about inflation. By November, the message had been flipped on its head, with the Governor telling New Zealanders to “cool the jets” and apologising for high inflation.

The change came as inflation expectations rose to their highest since 1991, as businesses lose belief that the Reserve Bank can and will get inflation under control. As a result, pricing strategies have shifted, with more businesses now looking to increase prices more often, and of a greater magnitude, to keep ahead of cost pressures.

Interest rates: a race to the top?

All of this comes after the Reserve Bank’s review of monetary policy between 2017 and 2022 that moving faster to reduce monetary stimulus, earlier, could have seen inflation peak lower. We’d note that Infometrics had been calling for larger, 50 basis point increases since August 2021, and called the decision to not go higher, faster in November 2021 “birdbrained and spineless” and that the Bank had “missed a chance to head off rampant inflation.”

Those fears have been borne out. Our July 2022 forecasts had a peak official cash rate (OCR) of 3.50%. By August, we’d increased this peak to 4.00%. In September we increased the peak to 4.50%. In October, after the hot inflation data, we increased the peak to 5.25%. We’ve now increased the peak to 5.75%. It’s worthwhile highlighting that a 75-basis point OCR increase would’ve been considered almost incomprehensible at the start of 2022. Now, not only has it actually happened, but the Reserve Bank seriously considered a 100-basis point move and is expected to start 2023 with a follow-up 75 basis point hike. That interest rate progression is similar to most forecasters, and importantly, the Reserve Bank itself.

The persistence and pervasiveness of inflation means that we’ve remained worried about the outlook for interest rates because of how unresponsive the economy has so far been to the increases. Recent strong GDP growth of 2.0% in the September 2022 quarter underscores the challenges.

Recession the fire break to stop the inferno

Fears of recession have been well-stoked at the end of 2022, as inflation remains alarmingly high, and rising interest rates don’t seem to have made much of an impact so far. Critically, there seems to be no sign yet of a change in business pricing sentiment, with sales and business revenue yet to be hit enough to shift pricing behaviour.

Looking through various figures, we’ve been trying to understand better why there’s been such a muted economic response so far. Although the declines in the housing market are clear to see, the change in the wider economy is difficult to find.

Part of this reason is that 20% of the owner-occupied mortgage book, and 24% of the investor mortgage book, is going to be repriced in the next six months. Infometrics estimates suggest that in October 2022, the effective mortgage rate was around 4.56%, compared to spot prices of 5.80% for a 1-year fixed term. By mid-2023, the effective rate will have risen to 5.53%, with more borrowers under pressure.

In addition, households have a considerable amount of savings that are still available to them. Data for the 2021 year shows nearly $18b in household savings (see Chart 1), which as a proportion of GDP, presents the highest household savings rate on record going back to the late 1980s.

Back in 1988, New Zealand households had a savings rate of 7.4%, but in 2021 this record was beaten by a rate of 8.9%. What this high savings rate means is that Kiwis have a much stronger household position to weather higher mortgage rates. Higher savings will also support higher sales for longer.

In our view, it may prove to be more difficult to engineer a recession, especially a shallow one. If that’s the case, a harder hit to the economy might be needed from the Reserve Bank to cause more widespread economic challenges.

So far, the economic impact of higher mortgage rates will be felt most acutely by those who bought in the last two-to-three years. Outside of that group, the economic challenges are reduced. But if the economic pain is too concentrated, there might not be the widespread pull-back in economic demand needed to reduce inflation. If that concern is true, then a wider economic hit is likely.

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