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Commonwealth Bank Global Markets Conference

Reserve Bank of New Zealand Chief Economist Paul Conway spoke at the CBA conference in Sydney, Australia online from Wellington.

Past Event
Tuesday, 25 October 2022 to Tuesday, 25 October 2022
10:00 am - 10:30 am
Sydney, Australia

Mr Conway discussed the August 2022 Monetary Policy Statement, and the Monetary Policy Review on 5 October 2022. He also shared his views on the challenges and opportunities for productivity in New Zealand.

August 2022 Monetary Policy Statement

Monetary Policy Review — 5 October 2022

Watch Paul Conway speaking at the Commonwealth Bank Global Markets Conference

Thanks for that introduction and thanks for having me on the call. It’s a pleasure to be speaking with you all. Apologies for doing it virtually. I would’ve loved to combine going to this conference with a long weekend in Sydney, but that was not meant to be. 

And indeed, the fact that I can just pop in on Teams, you know, I think I’ll talk about this a little towards the end of my intervention but it speaks to the incredible potential of digital technologies that they bring for a small and isolated economy like Aotearoa, New Zealand. 

Before I heard those opening remarks I was thinking that the timing for me giving a near term  what’s changed economic update was a little bit tricky because we’ve got a MPS – Monetary Policy Statement coming out in a few weeks. So I’m not going to talk much about near term economic issues and developments but I will talk about the inflation number that came out last week. But I’ll just sort of stick to the facts, I won’t interpret it in any way because I don’t want to pre-empt conversations around the Monetary Policy Committee table that are yet to take place.

Of course we will give a full read on our view of the world on November 23rd at our next MPS. So what I am going to talk about, which follows on nicely from those introductory remarks is the broader economic context that’s shaping that near term outlook and recent data developments. 

So I’ll start with a look at New Zealand’s big picture economic dynamics over recent years. Then we’ll spend a few minutes talking about the global economy and what’s been going on there and the effect that likely to have on New Zealand and I’ll end with a few thoughts on the supply side of the New Zealand economy and how events playing out in that space could work to our advantage over the medium to longer term, or not, depending on how we play our cards. 

So, that all might sound like it’s a bit big picture, and a bit real, in terms of the real side of the economy for a conference aimed at bond traders, but as I said, it’s quite consistent with those opening remarks. We are living through extraordinary times. It’s a really unique and a uniquely challenging period in our economic history. I think that sort of understanding the big picture is fundamental, certainly for a monetary policy maker, in terms of not messing it up and indeed for bond traders and banks. I think having a deep understanding of the economic fundamentals, of what we’re living through right now is also critical in getting it right, whatever that means to you – not screwing up in terms of your portfolios and positions, given the tremendous volatility in the economy and financial markets we are currently experiencing. 

Alright, so let’s start with New Zealand, we’ll start with inflation. Let’s look the beast, the monster in the eye. Inflation came out last week for Q3. It was stronger than pretty much everybody expected. In terms of The Reserve Bank, we had a 6.4 annual increase in CPI inflation in our August Monetary Policy Statement, and it came in at 7.2% so quite an overshoot there from what we were expecting – both tradables and non-tradables inflation were higher than expected. So, non-tradable sort of home grown inflation pressures came in at 6.6% versus our expectation of 6.3%. So not too much of a surprise there but still a big number, and that big number was driven in large part by construction costs and local council, local authority rates made large contributions as expected and when you sort of get down into that data you can see evidence of a sort of shift in consumer spending from goods back to services combined with a very tight labour market – you can see evidence of that throughout the CPI data.

Now the biggest forecast error that we did make was in terms of tradables inflation, so this is inflation coming over the border. That came in at 8.1% whereas we were expecting 6.5% so that was due to a 17% quarterly increase in fruit and vegetable prices –  huge number and we had a 20% quarterly increase in international air fares as our border has progressively reopened. We did have a 4.5% decline in petrol prices which was a bit of a partial offset. 

Now, a point I want to make here – tradables inflation is usually our friend. So over recent history, recent decades it has been low to negative across the globe and that's for a few reasons. First of all, you know globalization a sort of slow, moving positive supply shock has kept the lid on global prices. Relatedly, the Chinese labour market – so Chinese moving from sort of farms in the west to factories in the East and China being the workshop for the world has also contributed to low tradables inflation and favourable demographics across a bunch of countries has also contributed. But much of that is changing at the moment. So in the first instance, that's because of the pandemic and associated supply shocks but globalization is also changing. Demographics are changing and China isn't the deflationary force that it once was. So there's talk and serious academic papers arguing that greater international inflationary pressure could be a theme going forward — obviously hopefully not as extreme as what we've been witnessing over the last year or so, but that era of helpful tradables inflation may be coming to an end.

All right, so how did we end up with inflation at 7.2% in New Zealand? A rather unpleasant situation for all of us. So let's just take a quick look back over the last 2 and a half years or so. It’s obviously been a very bumpy ride in terms of GDP.  We’ve seen heaps of volatility over the last few years, given sort of intermittent lockdowns and associated health sort of aspects of the health response but overall, the New Zealand economy has done incredibly well over COVID. We sort of roared through COVID. We did see spending decline during lockdowns but then it would just sort of roar back out of lockdowns, you know as they came to an end. So the reasons for that, you know we saw a very strong policy response to the health emergency. We saw big government spending on things like the wage subsidy and of course we had ultra low interest rates. Our health response was also really effective. We pretty much eliminated COVID up until the end, oh sorry up until the start of this year. So, for about an 18 month period there, for many of us life sort of went back to normal while most of the rest of the world was battling and dealing with the virus.

Another reason demand stayed strong in our economy over this period is that we got really good at using digital technologies to work and to shop from home. So, we saw a big lift in the digital economy — while anything involving face-to-face connection or contact took a major hit which is a global story. That dynamic is ongoing to a large extent. This process of digital adoption —pandemics they often sort of reinforce or accentuate trends that were already underway in the economy and in society and digital adoption is clearly one such trend.

Other reasons why our economy stayed strong over that period — household balance sheets actually strengthened over the pandemic. New Zealanders, we actually saved over the pandemic. The housing market which we'll talk about more in a minute also helped strengthen household balance sheets with house prices going up pretty strongly over that period. So you know even now there's still a good buffer there. On average, household balance sheets are still in reasonably good shape. 

The labour market has also been crazy strong throughout the pandemic. We've got unemployment around 3.3%. The employment rate has been around record high. So workers, again a global story here, but workers have been becoming increasingly difficult to find, which is you know a fundamental change for New Zealand businesses. The labour market has really been a rock sort of supporting strong demand in our economy over recent years.

So for all of those reasons — a strong health response, household balance sheets in reasonable shape, really low unemployment, strong labour market, more generally domestic spending
and demand has stayed pretty robust. Of course, you know as I mentioned, it took big hits during lockdowns — particularly the one in March 2020, but then as I said at spending,
we've just come roaring back out of those lockdowns. We're also currently seeing tourism grow back reasonably strongly essentially from zero over recent months. So you know that's
that's the demand side of the New Zealand economy and it's been a story of strength at least so far.

All right, so on the supply side of the economy and again this is a global story — it's been a story of constraints. Perhaps most obviously migration. Net working age migration fell off a cliff going into COVID what with the border being shut and all, and net migration now is still negative currently but it is forecast to slowly pick up. So you know this is another fundamental change in New Zealand's economic model if you like.

Traditionally, we've grown our economy. New Zealand businesses, you know grow our businesses by throwing workers at them and but that model is sort of looking less likely going forward. I think migration inflows are always going to be important and beneficial for the host country and for the migrant but there are increasing signs that the days of very large inflows of low-cost labour into the country may be behind us. Indeed if you ask New Zealand businesses, labour is currently the biggest constraint limiting production across New Zealand businesses currently. All right so demand holding up — you know demand has changed in composition. It sort of went from services to goods during that lockdown period and now it's going back to services. On top of a very tight labour market we've had relative price shocks spilling over the borders given supply chain issues and the war in Europe so of course that equals inflation 7.3% in Q2 of this year. 7.2% in Q3 obviously too high but as you no doubt expect from a central banker, we expect to see inflationary pressures easing going forward, where you know we're hopeful that it has peaked and why do we think that? 

I just want to run through a few reasons why we see inflation moderating and I think you know in no small part, it's because monetary policy works. So the OCR — the official cash rate has increased from 25 basis points over the sort of lockdown period. It's currently 3.5% with financial markets pricing and further rate hikes to come as was mentioned in the introduction. So this is a very rapid tightening in monetary policy and it is starting to have an effect. There are early signs that the economy is starting to cool, that demand and supply in our economy are coming back closer into balance. I guess the most obvious sign is falling house prices. So house prices are down about 10% in aggregate from their high which was last November I think the end of last year, but some of the major centers have seen significantly larger declines in house prices over recent months. You know partly that's about higher interest rates but it's also about more sort of fundamental factors so slower population growth, looser zoning regulations across major cities. So you know again this is a big change for the New Zealand economy.

Traditionally we've sort of traded houses amongst ourselves at ever increasing prices thinking that we were creating prosperity but that's not what's going on currently. So we've sort of seeing a reverse wealth effect which should work to slow down consumption. Related to that, we're also seeing signs of a slowdown in construction activity. Consents — building consents have been
and continue to be very strong, but code of compliance work put in place that sort of stuff is starting to slow and they're certainly consistent with what we're hearing from industry
contacts. Unfortunately construction here it's a boom bust industry and we've actually it's been booming. We’ve actually been building quite a few houses over the past couple or 3 years, which is great and part of the reason why we're seeing this moderation in house prices. But there are lots of signs pointing to a sort of upcoming bust or at least a significant slowdown in construction activity.

Now let's sort of turn to the international front — the global economy and it's that kind of a question of where to start. Financial Market turmoil, growing signs of stress in the global economy. Global inflation is nudging double digits. We're seeing a coordinated tightening across central banks in most economy — certainly developed economies. We're seeing U.S dollar strength meaning currency depreciations for the rest of us and of course we've seen a bare market in equities.

Now I think you know when you get beyond the sort of hurley burley of financial markets and look at longer run trends in the global economy, you know those longer run trends are also giving us plenty to think about. As I mentioned earlier, there's a sense that globalization is changing compared to what we've become used to over recent decades. We've got huge geopolitical tensions. The global economy is sort of splintering into factions or clubs of countries. We’ve got a war in Europe and China has a number of significant issues confronting policy makers there and they’re sort of starting to turn inwards a little bit again.

We're also seeing governments getting bigger across the developed world. There's been a structural rise in spending and investment across many countries. To start with that's been about fighting COVID, fighting the pandemic but population aging means greater expenditure on health care. Geopolitical tensions means greater spending on defence. Climate change and energy security mean more investment in renewables and the like, and of course active industry policies are coming back into favour. Now offsetting this sort of tendency towards greater government spending is the fact of aging population. So older people, as we age, we tend to save more meaning higher savings in aggregate, which tends to sort of dampen aggregate spending in the economy but who knows how that's all going to play out.

All right, so there's some fundamental shifts going down around us. It’s certainly a great time to be doing economics. The optimist in me thinks that these changes could hopefully be the catalyst for sort of allowing the global economy to escape the sort of low growth period that we've been in since the global financial crisis, and to tackle some of the major problems confronting us, particularly climate change. But of course it could also signal - well it does signal huge challenges. From Financial Market chaos to central banks sort of running low on ammunition and out of control public spending going forward, so certainly it is game on people in terms of navigating our way through all of those challenges.

Now let me end just with a few words on New Zealand's longer term economic prospects. As I mentioned, 2 of the key growth drivers in our economy being the housing market and strong
inward migration has fundamentally changed.  The dynamics have changed. At least for the meantime, or it sort of raises the question you know where's economic growth going to come from in future. I did a number of years at the Productivity Commission so it's pretty natural for me to say it's going to come from a lift in our productivity of course, and I think that now is the perfect time to finally fix our relatively poor productivity performance. Now that's a huge challenge in itself, transitioning from an economic growth model that's being based on working more hours to one that's based on greater investment and technological adoption is obviously more easily said than done. We've been in a capital shallow sort of labour-intensive equilibrium for some time and it's kind of worked to some extent but that's a huge challenge to be moving from there to a more investment driven, high productivity, growth equilibrium.

But having said that, I think that transition is more possible now than certainly any period in my living memory. I say that you know, because of technology we're living through the 4th Industrial Revolution and behind all the chaos that is our day jobs. I think the biggest deal for us as I sort of alluded to at the beginning is that new technology makes it easier for Kiwi businesses to do business over distance. Economists, we talk about lower spatial transaction costs which allow businesses to expand beyond their geography — both domestically and internationally, makes it easier for small, remote firms to connect into large international markets. It makes it easier for Kiwi innovation to be noticed internationally. It makes it easier for us to tell our story. So that's the opportunity. As to whether we'll take it — this digital opportunity in front of New Zealand. There’s lots of work to be done in that space as well — education skills, innovation regulation, responding to climate change. Again it's a long list, but  the opportunity is there and I think the biggest sort of mistake that we need to avoid in this work is sort of the failure of imagination based on the assumption that today's regime is going to last forever. It never does.

Change is going to keep coming. Get ready.

So with that I'm going to leave it at that.

Thanks for your attention and listening.