Opinion: A deeper recession and bigger house price falls

By BNZ Markets Senior Markets Economist Craig Ebert The Reserve Bank quite rightly noted its inflation frustrations at last Thursday's OCR review. Core price and wage inflation remains far too high. And now the exchange rate has skidded well into "undervalued" territory, threatening to maintain upward pressure on the CPI. This would not normally be a recipe for a central bank to cut its cash rate at least another 100 basis points "“ as is the current market view for the earlier stages of next year "“ following the 100 points the RBNZ already lopped off last week. Yet a sum easing of at least that amount would seem fully justified on economic and credit-market grounds. To be sure, the New Zealand economy is better placed than most to weather the stiffening headwinds (including by way of its relatively sound financial system), but it has to do so with a domestic recession already well ensconced and with the global storm looking more and more vicious by the day. This is underwritten by financial market de-leveraging becoming aggressive - with equity markets the latest to be caught in the vortex. Such things will go a long way to ripping the guts out of the underlying price and wage inflation that had accumulated throughout the long boom years.

So instead of getting overly enthused by the many cushions that are appearing for the economy "“ such as the plunging currency, falling interest rates, tax cuts, petrol price drops and collapsing raw material and shipping costs "“ we are beginning to wonder if collapsing global demand will, in fact, put the kibosh on the gradual recovery we still expect for the New Zealand economy through next year. And if we can't expect a material GDP expansion then we'll need to feed that back into an even softer labour market, weaker business investment, and so on. A reminder of this was given by the June quarter house price index, as recently published by Quotable Value NZ. Yes, it's lagged. But it's the best quality index of its type, in our view. So it's worth waiting for. It dropped 4.5%. We believe a similar sized fall is likely to be recorded for Q3, with the annual decline now looking as though it will eventually plumb 15%, rather than the 10% we earlier forecast. Downside risks around house prices remain in full force. The same can be presumed for GDP, at least in the September quarter. We still estimate a 0.5% real contraction. To see whether this is a reasonable assumption, tomorrow's merchandise trade figures will be a test. To be frank, we've been surprised at the strength of export and import growth over recent months. The underlying trends continue to suggest a sharp deceleration for both is nigh. Not only are commodity prices slumping, but import volumes will surely soon shrivel in reaction to the stalling in domestic demand we've see through 2008 to date. For these reasons, we're picking merchandise export growth will subside to 15% y/y, from August's hulking 34%, with import growth moderating to 12% y/y, from 20%. This implies a monthly deficit of $550m, which would hold the annual shortfall to about $4.26b. We'd be surprised to see continued strength in September's exports and imports. However, the better test will be the Q3 trade summaries, published as part of the merchandise report. These will give estimates of seasonally adjusted value changes from Q2, and with export volume detail in parts. These, in turn, will be a test of our view that as part of the 0.5% decline we expect for Q3 GDP, goods export volumes rebounded a reasonable, if timing-related, 2.5%, while underlying imports were flat. Thursday follows up the house price thread with building consents and household credit, each for September. Following their extreme falls over recent months, we believe residential building consents are due a technical bounce for September. If they don't, we'll need to factor in an even bigger contraction in home-building activity than we already have by the end of this year. Non-residential consents values, though, will more surely flatten off even further in September. And, as the credit squeeze continues in full force, we'd be flabbergasted to see any pick-up in household borrowing in September's data, published Thursday afternoon. Most likely, we'll see another near record low increment of, say 0.4%, at most, which will further reduce the annual pace, from August's 7.2%. But the big news of Thursday afternoon promises to be the NBNZ business survey. Just when firms looked to be dipping their toes into warmer waters, along comes the latest, and greatest, wave of global distress. While this October survey will have missed the very worst of the dislocations it will surely have seen enough by mid-month to knock local confidence back into negative territory and activity expectation down to close to flat. Yes, the falling currency provides support. And falling commodity prices will benefit many a bottom line. But these will simply be buffers when the big concern is slowing global demand. Faltering growth prospects should, in theory, reduce pricing and inflation expectations. However, just like the Reserve Bank indicated at last week's OCR review, it would be good to see some hard evidence of it. Perhaps we'll get it in Thursday's business survey? What the NBNZ survey doesn't provide any clues on, though, is wage inflation. Yet it will be important in the RBNZ OCR equation too. So how can one ignore the Q3 Labour Cost Indexes and Quarterly Employment Survey? These are due next Monday. Sure, their respective wage and salary series can be jumpy. But assessing the underlying pulse will be worth a go. Continued high headline numbers, circa 5% per annum, will simply reinforce the need for a major slowdown. Surprisingly low wage numbers could be important in appeasing the Reserve Bank's inflation frustrations. * This economic outlook was written by BNZ's Senior Markets Economist Craig Ebert. All of the research from the BNZ Markets team of economists is available here.