Impact of interest rate hikes now building in economy
As it generally takes one to two years for monetary policy decisions to show their full impact, the Reserve Bank of New Zealand (RBNZ) and other central banks face the added issue of monetary policy lag in their fight against inflation. One reason for this is the time it takes for interest rate pass-through to come into effect given the use of fixed borrowing rates and the tendency of lenders to delay interest rate changes. As New Zealand’s current tightening cycle started about 19 months ago, it can already be said to be mature. It also follows that the full impact of the monetary policy decisions taken so far should now be building in the economy.
Mortgage market differences creating variation in heightening cycles
Although the current inflationary pressures and associated interest rate hikes are worldwide and central bank responses have been highly aligned, there are also notable differences in pass-through mechanisms among countries. In turn, this creates variation in monetary policy lags. In markets such as New Zealand and Australia, the mortgage rate is the key transmission mechanism and corporate investment activity is secondary, whereas investment in the corporate sector is more central to pass-through in the US. This is partly the result of differences in mortgage markets. Mortgages in New Zealand and Australia tend to have short, fixed terms of around two years. In contrast, extremely long terms of 30 years are more common in the US, meaning that mortgage pass-through is comparatively limited. At the same time, Australia’s particularly high use of variable-rate mortgages provides quicker pass-through than in New Zealand, where variable rates are less common. As a result, the Reserve Bank of Australia has paused its hiking cycle whereas the RBNZ is continuing to hike rates. Given the maturity of its heightening cycle, however, we feel that New Zealand will rapidly catch up with Australia’s position in 2023. Furthermore, as approximately 50% of New Zealand’s mortgages are set to be refixed in the coming year, a large number of borrowers will soon have direct experience of sharply higher interest rates.
Inflation to remain challenging in 2023 despite positive signs
Encouragingly for the RBNZ, the most recent New Zealand consumers price index (CPI) showed annual inflation declining from 7.2% in the December 2022 quarter to 6.7% in the March 2023 quarter. This was largely driven by a downward trend in tradeable inflation, which accounts for approximately 40% of total New Zealand CPI. Although the quarterly release schedule of the New Zealand data makes timely insights difficult, examinations of monthly proxy figures such as US headline inflation suggest that the worst could be over for this component of inflation. In our view, the tradeable figure could conceivably move towards zero in the next year as prices flatten out and a base effect reduction occurs. However, New Zealand is still a long way from a return to the RBNZ’s target CPI band of 1-3%. Tackling domestic inflation will require action to free up labour capacity, which will be challenging with unemployment at record lows and labour force participation at record highs. As a result, we think rate cuts are unlikely in New Zealand this year. At the same time, the impact of previous monetary policy decisions is set to intensify throughout 2023.