Dear Governor Orr,
There’s a pretty unanimous sense across Aotearoa’s financial markets right now that you’ve got another Official Cash Rate (OCR) hike in store for us this week.
The main point of debate seems to be whether you’ll go a little easier on us at 0.25%, or push harder with 0.50% - although, increasingly, markets are pricing the latter as a possibility.
Ultimately, if that is the path you take, you’ll have the markets’ backing. For the most part anyway. Many are saying that lifting the OCR is exactly what you, and the Reserve Bank, need to do right now. “A stitch in time saves nine” and all that.
But I beg to differ.
No matter how I look at it, my sense is that raising the OCR further is the last thing the Reserve Bank should do right now.
Here’s why.
1. Migration helps the Reserve Bank’s fight against inflation.
The surge in ‘pent up’ migration to New Zealand is forecast to hit 100,000 net arrivals in 2023, before levelling out to around 50,000 per year post-surge.
Economists, almost universally, have jumped on the “this will fuel inflation” bandwagon. But stand back, and migration is actually the best possible inflation-fighting tool.
In your November 2022 OCR announcement, Governor Orr, you said the RBNZ needed to engineer a recession, pushing unemployment up above 5% (from ~3.5%) to bring inflation under control. Lower demand for workers reduces the risk of a wage-price spiral, and dampens demand in the economy.
And, to me, that’s where migration comes in. Bringing the tens of thousands of workers to fill vacancies businesses so desperately need filled, and helping to take the heat out of wage pressure.
The flip-side, economists argue, is that immigration will push prices up by adding to demand. But what are migrants actually spending on?
- Rent? Yep –but rents will just continue to rise gradually, as they have for years anyway. And in my opinion there’ll be no surge there, with new builds continuing to increase supply.
- Food? Yes – but will food prices actually rise because of a 1-2% lift in population?I doubt it.
- Household furnishings? Sure – but this sector is pretty weak right now, and I can’t see too many supply constraints there that might cause meaningful inflation.
- Entertainment? Absolutely – but in a weak economy, added demand from migration will arguably be a welcome boost. And those ‘working holiday’ tourists are rapidly filling the hospitality sector labour shortage.
The other point I’d make is that retail spending volume has been falling for two years, and continues to trend downwards. With inflation, we’re just paying more for less (ouch!). Increased demand from migrants will have a badly-needed positive impact.
In short, my view is that the surge in migrants will see unemployment rise – but it won’t take Kiwi losing jobs (as was the Reserve Bank’s original plan). Rather it’ll happen as a result of a bigger labour supply, which will be a drag on inflation.
2. Monetary conditions are already set to tighten by 1.50% over the next year, based on the current 5.25% OCR
The average mortgage rate Kiwi are paying today is 4.40% - up from a low of 3.20% just over a year ago. A lot of households have only managed to make up that added cost thanks to repayment buffers they’d built up whilst interest rates were low.
Now, even if the OCR is held at current levels, the average mortgage rate Kiwi are paying is going to rise to 5.90% over the next year, as more people roll off lower fixed mortgage rates to higher levels. That’s another 1.50% to find on top of where we are now, and with repayment buffers much narrower.
Households are in for a world of pain
In short, monetary policy is on a steep tightening cycle for another year. Kiwi don’t need the screws tightened further via more interest rates hikes. They need someone to cut them a break.
3. The “no-frills” Budget isn’t expansionary. And it’s actually good news for inflation.
The media, and a few economists, have characterised this latest Budget as being more expansionary (or less “no frills”) than expected.
But according to Government Treasury forecasts in last week’s budget, inflation has already begun moderating, and will fall to 4.5% by the end of 2023, then be back inside the Reserve Bank's target band of 1-3% inflation by late 2024.
Some would point at policies like free public transport for under-13s, free prescriptions, 3000 more public homes (in a market where residential construction is shrinking) as fuelling inflationary pressures. But, to me, they seem smart policies for the economic environment, that will create downward impacts on inflation.
And one final reflection on Government policy. Fuel tax, road user charge, and public transport subsidies are all due to end on 30th June 2023. That means September 2023’s quarterly inflation statistic will be a big number – but the Reserve Bank will no doubt look through that and focus on underlying inflation.
In fact, I’ve seen a forecast that inflation will sit at 1.9% that quarter, so when you back out these subsidy removals, underlying inflation is much lower.
4. Actual inflation is falling – as are expectations around where it’s headed.
As you’ll know, prior to the latest quarterly inflation figures being released, just over a month ago, the Reserve Bank expectations had been that inflation would be 7.3% for the year to March 2023.
In reality, it came in at 6.7%, well below almost every forecast.
And as you’ll also know, on 12th May 2023, the Reserve Bank published a survey of 32 Kiwi business leaders and professional forecasters, around their expectations for where inflation will be in future. It came with the headline:
“Short and medium-term inflation expectations fall.”
Average expectations around the inflation rate “one year from now” have fallen by 0.8% compared to the December 2022 quarter. While average expectations around inflation “two years from now” fell by 0.5% to 2.79% – a figure that’s within your target 1% - 3% range.
To sum up…
While some might argue there’s cause for concern in the fact that wholesale interest rates have shifted upwards over the last week – perhaps suggesting that inflation isn’t quite under control yet – in my opinion that shift is inconsistent with underlying economic factors.
In fact, I’d suggest the rises are being driven by financial markets participants. After all, who benefits most from financial market volatility, if not the financial market traders?
What would I do? I’d hold the OCR at 5.25%, but make it clear that this rate is unlikely to be lowered during 2023. That will ensure the tightening monetary conditions for households are delivered, and see wholesale interest rates revert to the level they were after the April OCR review.
Patience is what’s needed here – and I know the Reserve Bank has it in spades.
I believe it’s now time for you to watch, worry and wait rather than throwing more fire-power at the inflationary dragon. A dragon that (many signs would suggest) is already on death’s door.
Governor Orr: Don’t kill the economy, and inflict even more pain on top of what’s already coming for Kiwi households, just to slay the dragon that little bit faster.
Cheers,
David Cunningham - Chief Squirrel