David Hargreaves explains what he is looking for in the economy in 2024 as we wait to see if the battle against inflation really can be won

In many ways the 2022 and 2023 years have felt like the middle episode of an economic trilogy.

The beginning of the story could be seen as 2020, with the start of the pandemic and then including 2021 and the fateful return of inflation.

The past two years have been the midpoint of our story, in which battle with inflation has been joined (by the Reserve Bank) and we’ve increasingly been cast into a kind of waiting mode to see if what the RBNZ’s trying will ‘work’.

As the lights prepare to go out on 2023 there’s clear signs of things happening. Inflation IS coming back down, although goodness knows, it has taken its time. The economy is turning down. Unemployment is turning up, though it has also taken its time. The things that NEED to happen to slow the economy enough to take the heat out of inflation appear to be happening.

So, 2024 has the look of being the beginning of the final part of our trilogy. It will be the Year of Finding Out.

We’ll get to find out if all the huffing and puffing with high interest rates really can get a proper grip on inflation. We’ll find out if a lot of us lose our jobs. We’ll find out if the economy slows enough that businesses start to struggle – and clearly some are already.

With that ‘big picture’ idea in mind then I am going to outline some thoughts on the things I’m looking out for in the economy over the next year. As ever I’m not making predictions as such, just seeking to identify what I see as the likely key issues and the way in which they need to develop – and also the way in which we DON’T want them to develop.

As I’ve said for a while, I still think the labour market is the most pivotal, issue. And maybe that does sound a bit odd when all the focus is on inflation. But we ain’t going to get inflation fixed unless the labour market plays ball.

Remember, the labour market got hot before the pandemic even started. But it then became searing during the pandemic as employers found they couldn’t tap into the usual safety valve of migrant workers. Unemployment at one stage got as low as 3.2%. I didn’t think we would ever see it get that low. We might not see it that low again.

With migrants now flooding in once more (and don’t worry I’ll have plenty more to say on this subject) that unemployment rate is going up, rising from 3.6% as of June to 3.9% in September. In its latest set of forecasts in the November Monetary Policy Statement (MPS,) the RBNZ forecast that unemployment will hit 5% in the September quarter of next year and peak at 5.2% in June 2025.

With the RBNZ having engineered a situation in which the unemployment rate is now going up, will we see the supposed Goldilocks, soft-landing, scenario where the rate does indeed settle somewhere just above 5%? Or is there yet the possibility this gets away on us and the rate goes somewhat higher? That could be bad. Kiwibank economists said recently, for example, that they reckon if the rate got above 7% that’s “when we start to see a more exponential rise in mortgage defaults…”

For those who remember the early 1990s, the unemployment rate reached over 11% and it WAS grim.

So, assuming unemployment does go up – but not by too much mind – then what about inflation? As mentioned further up the article, this has been taking time.

We need to consider inflation in two parts – there’s the ‘tradable’ overseas sourced inflation, such as through oil prices, and there’s ‘non-tradable’ domestically sourced inflation.

The RBNZ can’t do much about the first one, but very much takes aim at the second through usage of the Official Cash Rate. Since October 2021 the RBNZ has had to crank the OCR up all the way from the pandemic emergency setting of 0.25% to 5.5%.

Is it working? Well, the jury is still a bit out on that. Tentatively, yes, it is working, but this coming year will provide more hard evidence of whether it definitely is working and whether it will continue to work. We need it to work.

The ‘headline’ annual inflation rate as measured by the Consumers Price Index (CPI) peaked at 7.3% in June 2022 and has gradually made its way down to 5.6% as of the September quarter 2023.

However…

If we break down the figures into tradable and non-tradable inflation, things do not look quite so peachy.

In June 2022 when the ‘headline’ inflation figure was at that 7.3% peak, the tradable inflation was running at an eye-watering 8.7%. As of September 2023 this was down to 4.7% as the global impact of the massive supply chain disruptions has worn off.

But non-tradable inflation? As the economists like to say, this has been ‘sticky’. In June 2022 this was at 6.3%, before actually rising further and getting a high as 6.8% in the March quarter of 2023. Subsequently it has fallen to be 6.3% as of September 2023. But that’s still only the same as when the headline inflation figure was at its peak.

So, ‘sticky’ is the word.  We need to see meaningful falls in the rate of domestically sourced inflation over the coming year. If we don’t – problem.

The RBNZ is looking (according to its November MPS) for annual domestic inflation to be 5.7% in the December quarter, falling to 4.9% in March 2024, 4.2% in June and 3.6% in September 2024. So, quite a lot needs to go right. The RBNZ is forecasting that ‘headline’ inflation will re-enter its 1% to 3% target zone in September of next year.

Providing the domestic inflation rate does behave itself then we can rest assured that the OCR will go no higher than 5.5%. At the moment I still think that looks the most likely outcome, although the RBNZ is clearly not yet confident. Once we are assured the OCR won’t go higher the next question becomes:  When might the OCR start to come down?

The RBNZ won’t want to start dropping the OCR till it is fully convinced inflation is in the bag. A key question for next year though will likely be the extent to which ‘the market’ takes matters into its own hands and pre-empts the RBNZ by starting to reduce interest rates before the OCR is cut. The ‘hawkish’ warning issued by the RBNZ in its last OCR review of 2023 on November 29 can clearly be seen as an effort to head off such behaviour.

Prior to the RBNZ’s warning shots, the wholesale interest rate markets had already been pricing in three OCR cuts by early 2025, with the first cut occurring in mid-year 2024. The markets have backed off somewhat with the interest rate cut expectations after the RBNZ’s warning – but they will be back. The markets love to front-run developments. Therefore I still think it is valid to ask if will we start to see mortgage rates starting to come down early next year? It’s possible and it would be awkward for the RBNZ. The central bank would not welcome the markets effectively starting to ease monetary conditions before inflation is definitely on the run – and before the RBNZ is good and ready to start reducing the OCR.

The final big question on the high level economic details is whether or not we will see a very major downturn in the economy. The RBNZ had famously stated in late 2022 that it was deliberately trying to engineer a recession. But at time of writing that still hasn’t materialised – and the RBNZ is now forecasting that we will – narrowly - avoid one.

We are seeking the almost mythical, soft landing in which things slow but don’t come crashing down.

At time of writing, these key economic data do appear to be lining up well. A soft landing might be possible. Maybe this could work out all right. What could possibly go wrong?

Well, three words: Migration. Houses. Government.

If we are to get seriously tripped up next year, then it could be through some combination of those above three factors. They loom as a triple threat. In Part II of this 2024 preview, I’ll focus on those three things. Look out for that very soon.