As the Infometrics team has travelled the country trying to dodge the rain and catch some sun this summer, we’ve been pondering the economy’s prospects for 2023 – and those prospects are increasingly dark. It seems that a likely recession has rarely been as widely agreed on by forecasters or as well-signalled by policymakers and partial economic indicators.

From the beach 2023 provides a summarised history of recessions in New Zealand, examines why a downturn is virtually necessary within the next year, and looks at what the outlook means for key facets of the economy.

The conventional definition of a recession is two consecutive quarters with a reduction in economic output, as measured by real seasonally adjusted quarterly GDP. Using this definition, quarterly GDP data published by Stats NZ and Motu stretching back to 1947 shows that there have been 13 recessions in New Zealand over the last 75 years (see Chart 1). Ten of these recessions resulted in a contraction in GDP of between 0.7% and 4.1%. The three larger recessions were in 1948 (-7.7%), 1951 (-8.4%), and 2020 (-11.1%, although this recession was unique, being primarily caused by the supply shock due to the COVID-19 lockdown).

Stats NZ provides official estimates of annual GDP stretching back to 1955, and work undertaken by The Treasury in the early 2000s compiled additional unofficial annual estimates all the way back to 1860. Achieving a contraction in annual GDP is less likely than recording two consecutive quarters of negative growth, and using annual GDP figures only picks up eight of the 13 recessions that have occurred since 1947.

Nevertheless, annual GDP reveals an additional 12 periods of contracting economic activity between 1860 and 1947. These results are converted to per-capita growth rates, to remove the distortions caused by strong population growth at times in the 1800s, and presented in Chart 2. Unsurprisingly, the biggest drop in economic activity was a 12.3% contraction in GDP between 1930 and 1933 during the Great Depression.

Perhaps one of the most striking features of Chart 2 is the reduction in the variability of economic growth outcomes after the early 1950s. We see several possible reasons for less variable economic growth in recent decades.

• Data prior to 1955 is unofficial and is likely to be of lower quality. Historical GDP estimates have almost certainly been compiled from old, partial, and incomplete data sources, which means they are likely to be more variable than current GDP figures calculated based on the latest and widest range of available data.
• New Zealand’s economy has become larger and more diversified as the population has grown and activity has broadened across more and more industries. For example, a quick look at the value of New Zealand’s goods exports in 1923 shows that butter and wool each made up 25%, cheese was 14%, and frozen lamb 13%. In other words, four commodities from two animals made up more than three-quarters of New Zealand’s exports, with a value equivalent to approximately one quarter of the country’s GDP!1 Furthermore, over 80% of exports were destined for the UK. With such an intense concentration of output and export markets, it is small wonder that New Zealand’s economy was at the mercy of commodity prices and British demand.
• An argument can also be made that management of the economy has improved markedly as economic theory has evolved. Keynes’ critique of the policy failures that exacerbated the Great Depression was fundamental in changing fiscal responses to the economic cycle in subsequent decades. Similarly, Friedman’s theory has been at the foundation of monetary policy since the late 1980s. More stable economic outcomes have resulted as both fiscal and monetary policymakers have sought to dampen the swings in activity.

Although the last point implies that improved policy responses have led to less volatile economic outcomes, in the last 20 years policymakers have appeared to become increasingly fearful of any sort of slowdown or recession. The Global Financial Crisis led to an extraordinary collaborative response across fiscal and monetary policy, with massive bond-buying (quantitative easing) by central banks facilitating massive increases in government spending, alongside large bailouts of private sector banks that effectively socialised much of the losses associated with the Crisis.

At least some of this response was necessary to avoid a banking crisis similar to the one that occurred during the Great Depression. However, debate continues about the “moral hazard” created by the implicit willingness of the government to step in and bear the losses when things really turn pear-shaped. Additionally, there were fears that the combination of such large fiscal and monetary stimulus together could overstimulate growth and future inflation, effectively amplifying the next economic cycle. Although there was not really any acceleration in inflation during the 2010s, the aftermath of the COVID-19 pandemic has demonstrated that inflation can easily reappear if the economy is overstimulated in an effort to avoid downturns at any cost.

Perhaps an even more instructive example from New Zealand’s recent history is the monetary and fiscal policy response that emerged during 2019. Before 2020, when COVID-19 completely changed the game, the Reserve Bank cut the official cash rate by 75 basis points, and the government announced a $12b infrastructure package, to try and stimulate the economy because there were concerns that economic growth would slip below 2%pa! In our view, this approach seemed to be excessive micromanagement of the economic cycle given the inherent uncertainties in forecasting. Dampening the cycle too much also dampens the signals that encourage reallocation of resources across the economy from less viable to more profitable businesses and industries – a process that ultimately contributes to a more productive economy with growth that can be sustained at a higher average rate over time.

At its most simple, demand and supply have become incredibly imbalanced during the COVID-19 pandemic. Supply, both in New Zealand and globally, has been constrained by a range of factors, including lockdowns and other COVID-19 restrictions, bottlenecks in supply chains, disruptions to international shipping, labour shortages (including shortages caused by New Zealand’s border closures), and energy price shocks such as the Ukraine war. Many, but not all, of these supply-side issues are now resolving themselves, and we would envisage that global supply conditions will be largely back to normal by the end of 2023 (if not before).

At the same time as supply has been constrained, demand has been pushed to much higher-than-usual levels by ultra-low interest rates, large amounts of fiscal stimulus and government spending, confidence to spend arising from a very low unemployment rate and rapid house price inflation, and a catch-up in spending following periods of constrained activity (ie lockdowns). In addition, border closures resulted in the substitution of spending away from international travel towards other areas of spending such as homewares, renovations, recreational goods, or vehicles. Thus there were several areas within the economy that experienced an even larger surge in demand than economy-wide figures would suggest.

If demand exceeds the economy’s ability to supply (or meet that demand) for a sustained period, stresses are going to appear. Employees will be asked to work longer hours, with overtime likely to cost firms more. Businesses will be forced to pay more to attract or retain staff as headhunting and poaching become more common. Suppliers will not need to be as sharp or competitive with their pricing, recognising that there will still be sufficient demand to sell their products. Ultimately, there is more money competing over the same amount of resources, which forces up prices so that goods and services end up going to those people that can afford to pay the most for them.

The Reserve Bank’s initial interpretation of the acceleration in inflation during 2021 was that it was caused by supply-side factors and that it would be largely temporary. If temporary supply shocks were the whole story, then tightening monetary policy would be an inappropriate response because it would further undermine profitability for firms whose revenue had already been squeezed by disruptions to supply. However, it has become increasingly clear throughout the last 18 months that overstimulated demand has been a very big part of the imbalance story, and the Reserve Bank has been implementing an unprecedentedly large set of interest rate increases to try and bring demand, and inflation, back under control.

As alluded to in the previous section, a downturn in the economy has the “benefits” of exposing the least profitable or viable businesses and cleaning out some of the dead wood in the economy. Although this process is an unpleasant one for the people most closely affected, it ultimately stands the economy in better stead for growth over the longer term. The reallocation of resources within and between industries is an important part of a healthy and well-functioning economy.

Some of the greatest collateral damage as the Reserve Bank raises interest rates is occurring in the housing market. According to REINZ’s index, house prices in December 2022 were down 14% from their peak in November 2021 (see Chart 3). The largest falls to date have occurred in Wellington (23%) and Auckland (20%).

Falling house prices would normally be viewed as a negative for the economy, being associated with weak consumer confidence, reduced appetite for spending, and lower levels of residential construction activity. All these correlations currently remain valid.

However, the surge in property values that occurred during the second half of 2020 and 2021 took house prices to exceedingly unaffordable levels, and was largely driven by the ultra-low mortgage rates that prevailed during that period. In this regard, the increase in house prices during the pandemic was unsustainable, particularly given that housing was already relatively unaffordable even before COVID-19 came along.

To put the current housing “correction” into perspective, house prices are still 27% higher than where they were at the end of 2019 (see Chart 4). Even considering an increase of around 15% in average wages during the same period, housing is still less affordable than it was prior to the pandemic. Further price falls are necessary to bring housing affordability back to a level that doesn’t leave aspiring first-home buyers saddled with a lifetime of massive debt repayments. In this context, the negative repercussions of a housing market correction are a lesser evil than perpetuating the housing affordability crisis that has built up in New Zealand throughout the last 20 years or longer.

One of the difficulties the Reserve Bank is facing as it tries to quell demand and rebalance the economy is that much of the effects of higher interest rates have been concentrated among a relatively small pool of people, at least to date. As recently as August last year, the lowest available mortgage rate was under 5%, a rate that was not particularly concerning for anyone who bought their home prior to the pandemic, for two reasons.

• Firstly, mortgage rates were between 4% and 5% between early 2016 and early 2019, so the debt-servicing costs at these mortgage rates were affordable for longer-term mortgage holders.
• Secondly, the ultra-low interest rates during 2020 and 2021 will have seen many people pay down their debt faster than they would have been able to otherwise, meaning their regular payments will now be lower than pre-pandemic at the same interest rates.

As a result, the effects of rising interest rates on household spending have so far been heavily concentrated among the relatively small pool of buyers who entered the housing market or expanded their property portfolio in 2020/21. Many of these buyers borrowed heavily on the expectation that interest rates would remain low for an extended period. Much higher-than-expected mortgage rates have already started to stretch these households’ budgets and will continue to do so throughout 2023 and into 2024.

Further dampening the timely effectiveness of the Reserve Bank’s tightening in monetary policy is the dominance of fixed lending in the mortgage market. By November last year, just 11% of all mortgage lending was on the floating rate (see Chart 5), with about 55% of fixed lending due to come up for renewal within the following 12 months. The prevalence of fixed mortgages means that official cash rate increases are likely to take 6-12 months, on average, to have a concrete effect on household budgets.

All these factors mean that the Reserve Bank is having to take greater action, and increase interest rates further, than might otherwise be the case. The need for tighter monetary policy has also been exacerbated by the Bank’s relatively slow and cautious start when raising interest rates in late 2021 and early 2022, which meant the Bank lost some of its control over inflation expectations and pricing behaviour. The Bank is now battling to regain its inflation-fighting credibility and reduce the momentum that the inflation juggernaut has built up.

Although the Reserve Bank’s efforts to rein in demand have been slow to take effect and highly concentrated to date, increases in unemployment over the next 18 months will spread the pain more widely. The unemployment rate is set to climb by more than a percentage point during 2023 and push up to 5% during 2024. These job losses and the associated reduction in income security will weigh on spending activity across a broader range of households, eventually achieving the Reserve Bank’s aim of reducing demand back to more sustainable levels.

The implications of these trends for businesses over the next two years are relatively clear. Attracting the consumer’s dollar will become increasingly difficult between now and mid-2024 as households find they have less money to go around. Mortgage rates are on the verge of climbing above 7% for the first time since 2008, taking away a significant chunk of money across many households that would otherwise have been used for discretionary spending. Lower employment confidence will also reduce the willingness to spend, with an increase in unemployment obviously hitting affected households particularly hard.

Retailers are already showing through as one of the most pessimistic and heavily squeezed sectors according to the NZIER’s Quarterly Survey of Business Opinion (QSBO). Business confidence for the sector, along with indicators of sales activity and forward orders, are at their lowest since the Global Financial Crisis and, in many cases, their lowest on record (some data series stretch back to 1962). But with cost pressures still high, profitability is coming under severe pressure. More business failures are likely over the next two years as the retail sector goes through a period of contraction and consolidation.

Although some recent housing data has suggested that the ongoing declines in house prices could be starting to moderate, we expect that house prices will continue to fall throughout 2023 and into 2024. Higher mortgage rates will limit the borrowing and servicing ability of buyers considering entering the market, maintaining a cap on the price they are able to pay for properties. These weak demand conditions will coincide with a significant increase in the supply of housing as the backlog of consented dwellings is completed and brought to market. We recognise that some of these consented homes will not be built as developers react to reduced sales and enquiry levels, but the increased supply of new homes will be sufficient to drive house prices further downwards across the board.

It hardly qualifies as news, but the latest QSBO also reiterated the mounting concerns about prospects in the construction industry, particularly around residential activity. Having been one of the strongest growth industries throughout the COVID-19 pandemic, significant declines in activity and employment are on the cards during 2023/24 as demand for residential work responds to higher interest rates, lower house prices, and the slowdown in population growth that has occurred since the borders were shut in early 2020.

Having affected the economy since 2020, critical labour and skills shortages will become significantly less acute over the next two years. The border reopening and the government’s immigration Green List have seen foreign citizen arrivals for the period between September and November 2022 recover to 90% of their pre-COVID (2018) levels. This improved access to foreign workers is partly reflected in the QSBO, with some indicators suggesting that the labour market is on the cusp of easing. The recent rapid moderating in job ad numbers also supports this view.

For many businesses (outside tourism and hospitality), the looming recession has meant their appetite for increasing staff numbers is waning. As 2023 progresses, pressure on revenue and profitability is likely to see firms consider consolidating their workforces, through natural attrition or a reassessment of more expensive workers that were taken on during the pandemic.

This bleak economic outlook is bad news for the Labour government hoping to be re-elected later this year. There have already been signs in the latter part of 2022 that the government has started to lose its connection with voters, with the entrenchment saga around the Three Waters legislation being a prime example of the type of arrogance that might normally be associated with a third-term government.

At this stage, the polls remain too close for us to be confident about a change in government at this year’s election. Recent polls have generally shown National and ACT obtaining a narrow majority. However, the problem for Labour must now be that the economic environment will get markedly worse throughout 2023. Many voters are unlikely to care that higher interest rates, falling house prices, and rising unemployment are not direct results of the government’s actions.2 We would not be surprised if, in six months’ time, the polls are clearly showing that the next government will be led by National. However, incoming Prime Minister Chris Hipkins has immediately recognised the disconnect with voters and the importance of the economy, and we continue to monitor the government’s work programme and intentions across the economy heading into the 2023 election.

Our next set of forecasts for clients will be published on Friday 3 February, providing a greater level of quantitative detail about the outlooks for consumer spending, the housing market, and the labour market throughout 2023 and beyond.

1 By comparison, New Zealand’s four largest goods exports categories in the June 2022 year were: milk powder, butter, and cheese (28% of total goods exports); meat and edible offal (15%); logs, wood, and wood articles (8.0%); and fruit and nuts (6.2%). These categories are broader than the ones published 100 years ago, and total only 57% of total goods exports. Even more importantly, their total value is equivalent to just 10% of GDP.

2 Nevertheless, massive fiscal stimulus has been a contributing factor to the boom in the New Zealand economy in the wake of the 2020 COVID-19 lockdown and, therefore, the need to raise interest rates and reduce demand that is now dominating the outlook.