Interest rates, uncertainty, fiscal risks

It all seems rather strange.

The Reserve Bank last week kept the Official Cash Rate at 5.5% while also saying another hike was possible for 2024 and that rates might only be cut in 2025.

While no change to the cash rate was expected, the comments surprised.

They not only dampened mortgage holders’ hopes for rate falls but were also treated with scepticism by banks and some economists.

Basically, the markets did not believe the Reserve Bank. They looked at what was happening overseas, especially in the United States. China is facing deflation, oil prices have been stable and shipping rates and supply chain issues have settled.

What is called bank "two-year swap rates" fell from early last week.

Independent economist Tony Alexander said he thought the talk of raising the cash rate next year was just a threat. Others thought the Reserve Bank was bluffing, endeavouring to "jawbone" down demand to help cool inflation.

The Reserve Bank argues that employment is beyond sustainable levels pushing up labour costs. Record immigration was stimulating demand — notably on rents and house prices.

Inflation continued to be far too high.

The Reserve Bank of New Zealand in Wellington. PHOTO: REUTERS
The Reserve Bank of New Zealand in Wellington. PHOTO: REUTERS
Last week, too, the Organisation for Economic Co-operation and Development (OECD) predicted slow growth. It, though, largely backed the Reserve Bank on the need to keep interest rates high to fight inflation.

It also said financial and structural policies were needed that would help counter inflation and even out imbalances "rather than adding to demand via tax cuts or other non-targeted subsidies".

This all illustrates the uncertainty and choppy seas ahead. The economy, and by extension the economic wellbeing of the country and individuals, depends on successfully sailing ahead.

All adjustments to the sails, as well as external wind shifts, have a series of implications.

Finance Minister Nicola Willis will be well aware of the need to seek the correct balance as her pre-Christmas mini-budget is prepared and as other policies are introduced.

Take the tax cuts to which National is politically committed. Clearly, putting more money into people’s pockets — albeit a relatively small amount and insufficient to compensate for the tax increases through tax-bracket creep over the past several years — will add to inflationary pressure.

The coalition therefore had to try to reduce its spending and the volume of the already sizeable deficit. How successful will those efforts be? How difficult will it be to cut the size of the public service?

Likewise, the changes in tax deductibility rules for landlords have an obvious fiscal impact on the government because of less tax revenue.

What, though, might be the effect on house prices? Will high mortgage rates — still flowing through to borrowers — be a sufficient drag on the increases beginning to be observed?

But, because of the excessive building costs in New Zealand, are higher house prices now necessary again to rejuvenate the slowdown in new-house building?

In turn, more homes should mean less upward house price pressures.

Another dilemma is that the government needs unemployment to rise to ameliorate inflationary wage-price spiral effects. But with increasing unemployment and less spending comes less income tax and less GST as well as increased welfare spending. Every government decision has economic, as well as political and often social, ramifications — directly and indirectly.

Then there is so much outside the government’s control. Might El Nino weather reduce agricultural production and slow the economy and therefore reduce inflation? Might commodity price falls do the same thing?

The Global Financial Crisis of 2007-08, the Canterbury earthquakes and Covid are prime examples. The Covid inflation stimulation and debt hangover still reverberate heavily.

Governments do their best to blame previous administrations. Ms Willis has already said: "The outgoing government has left us with some nasty surprises."

She added: "There are some fiscal risks that are pretty significant that we’re going to have to work hard to manage."

There are indeed. The future of her government and the prosperity of New Zealand will depend on that management.