Bad news has become good news with interest rates coming down, setting in motion a better economic climate for 2025.

The catalyst has been a third recession in two years, only this one has really broken the back of pricing behaviour. Tough times have crimped spending, meaning discounting has become more widespread as firms seek to shift product. 

Firms have spare capacity for work, so the pricing of work becomes sharper, especially in construction. Higher unemployment has tempered wage demands as job security becomes more important.

This is the basic disinflation playbook. 

There are still some sticking points that will add some persistence to inflation. Local authority rates and energy prices being examples not linked to the economy at all. Geopolitical concerns at any time could set of further disruptions to supply chains or oil prices.

However, there are enough “bad news” economic disinflation forces that point lower for inflation to give the Reserve Bank of New Zealand comfort to start cutting the Official Cash Rate (OCR).

With an easing cycle underway the obvious question is how fast and low will interest rates go?

The trajectory for inflation will have a big say over how fast they can fall. A steady decline in interest rates over 2025 is dependent on the RBNZ’s “confidence that pricing behaviour remains consistent with a low inflation environment, and that inflation expectations are anchored around the 2% target”.

Let’s assume it all goes to plan and inflation keeps falling.

The first port of call for assessing how low they will go is the neutral OCR. This is where the RBNZ has the foot on neither the accelerator nor the brake. Think of it as when the RBNZ is on holiday basking in the sunlight of having inflation at 2% and not having to do a lot.

The neutral OCR has moved over time.  Back in 2000, it was up around 5% and the OCR wobbled around it. By 2020 it was estimated to have fallen to 2%, allowing interest rates to be a lot lower on average.

If policy rates are below the neutral rate, policy is stimulatory and, conversely, rates above neutral make policy contractionary.

The RBNZ estimates the neutral OCR is now around 2.75-3%, which it is projecting the OCR will fall to. Demographic changes, productivity growth, and changes in consumers’, businesses’, and governments’ attitudes towards savings and investment can all influence the neutral OCR. Future neutral interest rates may be higher due to de-globalisation (adds to costs), ageing populations as they start to spend as opposed to save, decarbonisation (adds to costs and inflation), and higher government debt. 

Westpac economists and I put the neutral OCR around 3.5-4%.

Irrespective of the RBNZ or Westpac view of the neutral OCR, the good news is that they are both well below the current level of the OCR.

Historically, monetary policy spends periods both contractionary (above neutral) and stimulatory (below neutral), and here we are simply talking about rates going back to neutral from a period of being contractionary.

Other factors will also play a role over the coming years on borrowing costs. Two key ones are bank funding costs, of which the OCR is one factor, and the pricing of risk relative to the taking of it.

As people have invested more in term deposits in recent years, this has added to bank funding costs. As the Funding for Lending (FLP) programme also winds down (which gave the banks cheap funding from the RBNZ), banks will likely replace FLP funding with retail and/or wholesale funding, although this is more expensive.

New Zealand has a clear structural problem where home lending is being prioritised at the expense of lending into the real productive sector. There is also a related issue regarding the pricing of risk (think bank margins, which drive profits) relative to the taking of risk (think about the volatility of bank earnings, which tend to be very stable). The Commerce Commission has highlighted an inconsistency between the two. Banks deliver superior returns without the risk.

This is where a key part of the upcoming Finance and Expenditure Committee’s inquiry into banking competition needs to focus.

Rural lending will always be more expensive than residential lending. Banks need to hold more regulatory capital against the former. This inquiry needs to put the spotlight on the risk-adjusted returns across residential, business and rural lending, though. We need to see attention on the return on capital from business, rural, and residential mortgage lending.

The bottom line is that lower interest rates are welcome news but there is still some uncertainty over the magnitude of the decline we will see. Assuming inflation remains contained and monetary policy goes back to neutral, a 150-225 basis points drop in borrowing costs from the peak seems in the ballpark with the lower estimate based on a higher assumed neutral rate and the impact of some changes in bank funding costs.

More sunlight on bank rural lending margins could accentuate more competition and that projected decline in borrowing costs.

An under-appreciated factor supporting the New Zealand economy in recent decades has been the terms of trade, which represents the ratio of export prices to import prices. Farmers are more concerned about the former, but it is the combination that matters.

New Zealand’s terms of trade rose almost 45% between 2001 and 2021. This allowed us to purchase more imported goods for every unit of export that we sold.

The terms of trade are now down almost 11% since 2021. This means New Zealand must export a greater number of units to purchase the same number of imports to keep our trade balance and current account in check.

The finger can be pointed at commodity prices (weak), and oil prices moving around, but the real issue is, has New Zealand’s terms of trade hit an inflection point? If it has, where should we turn for growth?

Many decades ago, the Prebisch-Singer hypothesis stated that the price of primary commodities should decline relative to the price of manufactured goods, which causes the terms of trade of primary-product-based economies to deteriorate. As incomes grow, we are assumed to spend more on manufacturing items, which have a higher income elasticity compared to food. 

At face value this was bad for New Zealand, but the outcomes did not mirror the hypothesis. Our terms of trade rose.

A key reason was the rise in globalisation, which reduced the price of manufactured goods, particularly as outsourcing took hold and China became the epicentre for lots of manufacturing.

As the world became more and more connected, accessing cheap labour, and outsourcing to cheaper and low-cost producers took place, manufacturing goods become the new commodities.

New Zealand also benefited from lower prices for many capital goods, which incorporated falling prices for computer equipment. A computer built in 2001 is far less powerful than the ones we have today.

Other factors, such as relative inflation rates, trade policy and the currency, can play a role too, but the defining factor appears to have been globalisation and shifts in manufacturing pricing relative to commodities.

A debate is now raging over whether globalisation is over, or are we just moving into a different version of it? I side with the latter.

Globalisation has a tailwind in the form of technology. This reduces the tyranny of distance. The economics of trade is also clear – a more globally connected world boosts growth. The global economy will need interdependence and co-operation to crack climate change objectives and reduce poverty.

However, globalisation was always going to face challenges at some point. There was always going to be a stage where the integration of world views, products, ideas and culture into a universal set of values would face realities. Not everyone wants to be like the West who have modernised the most, and nor should we expect them to be.

Convergence is now divergence. Geopolitics is moving against globalisation and potentially a world dominated by two or three trading blocs. The economics of trade now has a security overlay, especially in technology. 

Just-in-case is replacing just-in-time, our rules-based trading system is being challenged by the use of power, and protectionism is rife. As New Zealand’s chief trade negotiator Vangelis Vitalis puts it, “the golden era is over”.

How this impacts export and import prices over the medium term (looking beyond the current period) is open to debate. Supply-demand balances within various markets for commodities will remain influential.

However, we would be amiss not to acknowledge that if globalisation was one driving factor behind a rising terms of trade, even a partial reversal will not be good. The Prebisch-Singer hypothesis finds some favour in the literature but the 2000s commodities boom saw the terms of trade of most developing countries improved, while east Asia (which exports mostly manufactured goods) saw deteriorating terms of trade (though that was the booming China driving commodities, not the current China). 

Where is the good news? 

The primary sector is primarily concerned about absolute prices rather than relative ones, yet it is the relative prices that matter for the overall economy.

A lower terms of trade will need to be counteracted by a currency that supports exporting over importing. We are seeing that.

The terms of trade is one of many “old” drivers of the economy that have likely reached peak-influence.  China’s growth prospects have weakened though India’s era is here. Interest rates will fall over coming years, but the trend will not be lower for the next 30 years like the previous 30. That will dampen capital gains. 

A housing-centric growth model of 30 years just exacerbated unaffordability, inequality and division. Tourism is struggling to recover to pre-covid levels. Migration has been an easy lever not a substantive one. This model allowed us to get away with average (at best) policy and business practices. Sub-par practices and policies are now being exposed. Witness electricity.

Our “new” growth model likely has four essential components. Address poor productivity. Get the right settings for capital investment, which includes examining banking and the pricing of risk relative to the taking of it. Natural resource endowments need to be unlocked. Government policy and business execution needs to step up.

It’s a more substantive model than previous ones. We need the tough times to embed the shift to the new model and especially better policy.

Why are we not seeing real stress across the economy? We hear about lots of stress, and it is apparent in areas. But is it really that bad? Those with very long memories likely say no.

Based on some of the economic data, we should be seeing a lot of stress. The economy has contracted in four out of the past six quarters, gross domestic product (GDP) per capita has fallen 2.4% in the past year, equivalent to the global financial crisis and other shocks such as experienced in the 1970s.  Food banks and social agencies are reporting pain. So too are many rural communities.

Yet bank non-performing loans (NPLs) are 0.7 percent of total loans. That compares to more than 2% in 2011. NPLs are less than half what they were during the global financial crisis of 2009.

NPLs across the agriculture sector currently stand at 1.8% of total loans.  We’ve seen that hit 4.5%.

There are are a few possible reasons.

The economy is actually not that bad on many levels. The unemployment rate is still 4.3%, though predicted to rise to more than 5%.  That peak is not high either.

Households have saved more than $20 billion since before covid-19 hit, boosted by a government wage subsidy transfer. That savings buffer is not yet being eaten into in aggregate, though we know cost of living pressures are huge in parts of society. Term deposits at banks have risen more than $50bn in the past two years with 6% rates on offer. Baby-boomers are spending.

During the period of low interest rates, many kept their payments unchanged, paying more in principal and getting ahead of debt repayment requirements. The full impact of refixing at higher interest rates has yet to hit. Dairy farmers have been amortising debt.  

The economy has stalled, under the weight of higher interest rates, but a fair chunk of the pullback has been moderation from extreme highs in areas such as construction. It has only been in 2024 where work is running out.

A lower NZD/USD has been somewhat of a saviour for the primary sector and looks set to remain so.

While GDP per capita is down, GDP is basically flat on a year ago, helped by a large surge in migration.

Debt burdens are lower in certain sectors such business and agriculture. Agriculture debt has risen a slow 5% between the end of 2016 and 2024. Dairy debt, which accounts for a huge share of agriculture debt, has fallen 10%.  This has somewhat mitigated the impact of higher interest rates. Regulatory restrictions such as loan-to-value ratios have reduced credit excesses.

Banks now always take security on lending because of their credit risk models. Security provides a second way out and ensures a lower loss given default and commonly no loss or a writeback of a provision. That is taking less risk.

It might just be question of timing. The real economic stress lags economic outcomes as we saw after the global financial crisis. Asset values are taking time to realign to the impact of higher interest rates and profitability. There is a standoff between buyers and sellers.

An improved economic outlook, which is projected for 2025, could take time to get growth back to levels needed to sustain many business operations. The same with some commodity prices (income) relative to cost structures. 

How quickly will demand recover for red meat in China is a key question. The extent of the rise in farm cost structures in recent years will remain a problem for 2025 at least. Cost curves tend to flatten, not decline, and there are costs that are still rising rapidly from areas such as local authorities.

This business cycle is more than a downturn. It is a realignment with huge structural changes interplaying with near-term drivers such as inflation and interest rates. 

The government has altered the environmental landscape in the near-term. This has bought farmers time; it has not altered the long-term challenge. 

A lot of investment and change is required to transition to a lower emission environment. Trade connectivity and deals are being aligned to achieving environmental and sustainability standards.

How much risk have banks been carrying with their lending? They price for risk through their interest margins. However, as banks’ appetites for writing home loans over agriculture and business loans in recent years has increased, so too has the strength in their lending portfolios. That can be a good thing in times of difficulty but at what cost for growth and productivity?

The pricing and taking of risk is one element of a well-functioning economy and that requires strong credit intermediation and risk appetites. Are the current low levels of NPLs symptomatic of less tolerance for risk in recent years and the preference for home lending? If so, has less tolerance for risk be matched by narrower lending margins?

We also have less visibility on financial pressure beyond the banking sector, especially in areas such as consumer finance.  

The bottom line is that there is stress across the economy but not of the intensity we have seen in previous cycles. That might just be a function of timing, more conservative lending, the fact this downturn has yet to reach the nadir, the extent of economic risk in bank lending portfolios, or that we have yet to see the full impact of level shifts in things such as costs, structural shifts around the globe such as Chinese demand, and downwards pressure on asset prices.

In the May Monetary Policy Statement was a special feature on exports.

It highlighted a stark trade-off. Constrained export growth means resources are deployed elsewhere. That redeployment and less growth from agriculture (a 2% productivity year industry) is likely one factor contributing to slower productivity growth, which means slower growth in living standards.

Exports of goods have declined as a share of GDP. New Zealand’s goods exports as a share of the economy have been on a downward trend over the past decade, from their 2013 peak of 22% to about 18% at the end of 2023.

The Reserve Bank of NZ notes that export growth has gone from 4-5% per year in the late 1990s and early 2000s to 2.5-3.5% in the 2010s. That’s barely above inflation.

That means resources such as labour and capital are being deployed away from exports into other parts of the economy such as domestic demand, and particularly housing.  We can see that in a bank lending statistic that shows home lending has gone from around half of all lending in 2010, to 63% now. Home lending has gone from 57% of bank lending to 63% in the past five years, partly driven by banks being required to hold more capital. That has simply encouraged them to write more loans on assets the banks need to hold less capital against.

Goods exports are dominated by agriculture, which has seen multi-factor productivity growth (the combined efficiency of labour and capital) on average of just under 2% from 2008-2023 compared to 0.2% for measured sector of the economy in aggregate. 

Primary sector productivity is good; food, beverage and tobacco manufacturing productivity is not, with negative average multifactor productivity growth from 2008 to 2023. Construction sector productivity has averaged -0.1% per year.

I noted last month in my Farmers Weekly column that productivity for the New Zealand economy averaged 1.4% per annum between 1993 and 2013 but averaged only 0.2% per annum over the past 10 years. We have relied on migration for growth, which of course stokes demand for housing.

The Reserve Bank revised down its outlook for exports in May, citing the outlook for free trade agreements, slower growth in China and the impact of environmental protections. China’s growth per year over the coming six years is expected to be roughly half (3.9%) what it experienced between 2010-2019, which was 7.7% each year.

Contrast that with the government’s aspiration to double exports.

The real kicker, though, is what poor export performance means for our living standards if exports continue underperform the general economy, meaning resources could continue to transfer to less productive areas.  The RBNZ notes, “To the extent that this reallocation results in lower productivity growth, this contributes to lower potential GDP growth.” Aka, it makes us relatively poorer.

A low productivity economy cannot grow as fast as a high productivity one without generating inflation. It forces the central bank to apply the economic brakes.

One release valve helping exports is likely to be the NZ dollar settling in a low range. Slow growth in exports doesn’t just constrain growth and productivity, it contributes to a wide current account deficit. 

The RBNZ is projecting the current account (our national cheque-book with the rest of the world) will remain above 6% of GDP (in the red) over the coming two years. A wide “current account deficit increases the risk of a depreciation of the real New Zealand dollar exchange rate over the medium term”.

Deteriorating export performance is of increasing concern. Goods and service exports have fallen from 31% of GDP to 25%. The finger cannot be pointed at tourism, which has largely recovered post covid. The decline has largely come through the exports of goods.

We are not the small open trading nation we claim to be, seventh from the  bottom of the OECD in total exports as a share of GDP. We slipped below the OECD average in 2015 and the gap is now around eight percentage points.

Constrained export growth, via slower growth in China, environmental restrictions or rising protectionist vibes, are subset of a lot of issues. Disruption caused by the effects of climate change another, though water storage, if we can accelerate it, can help manage some of that risk. Water could be a huge enabler.

The NZD/USD has been above its four-decade average for almost three-quarters of the past 10 years. The NZD is only now settling consistently more in exporters’ favour, with the exception being the NZD/AUD that is still above estimates of fair value.

There are a host of infrastructure bottlenecks that need addressed, including Port of Tauranga’s capacity and State Highway 29. We need to be focusing more on such examples of supply-side factors. A trade-deal is worthless if you can’t supply the product.

That includes getting bank regulatory settings right. 

Declining education attainment, low managerial capability and under-investment in research and development were identified in the OECD’s Economic Survey of NZ as key issues.

Exports are a key driver of economic growth and living standards. The trend in exports is not getting the attention it deserves, nor are the downstream implications of resource redeployment into less productive areas.

We are entering the difficult stage of the economic cycle when cyclical challenges need to be addressed but structural change is needed at the same time. 

This is where the real pain starts, but also opportunity – where pain brings more appetite and need for change.

The recent financial results of Briscoes Group highlight a critical point. When you face macroeconomics headwinds you are reliant on microeconomic tailwinds. We are starting to find out which organisations have the better microeconomic credentials. Eyes will be on the red meat industry.

Last year was the appetiser for the macroeconomic main course. Non-performing loans are 0.7% of all loans. The proportion of loans in agriculture that are defined as non-performing is 1.6%  Back in 2010, they were more than double that. 

This coming year will be dominated by two variables and one variability. Inflation, the economy’s productive capacity to meet demand – the money line for the economy that needs to be repaired – and geopolitics.

You do not get rid of inflation if the economy is going well. Good times are inconsistent with people tightening their belts, a prerequisite to businesses discounting or pricing sharper to get business.

The world is trying to get rid of inflation, so the global economy is not going to be strong. Core inflation in the United States is starting to level out, still considerably above the 2% target. 

There is a growing risk that central banks and the US Federal Reserve will need to resume tightening. That could drive the New Zealand dollar lower. 

Locally, the earnings reporting season was not good news overall with big hits to Fletcher Building, and The Warehouse Group ejecting Torpedo 7 for $1. 

Building consents continue to fall, some consented projects are being paused or cancelled, and retail sales volumes have fallen eight quarters in a row. 

We are seeing more tourists, though, and migrants.

Improving business sentiment post the election has not been matched by reality. Business optimism is probably hope that we’ve seen the worst of it and that the new government will fix it.  Good luck on both counts.

Demand needs to remain weak, and that will be concentrated and worst felt in interest-sensitive parts of the economy such as construction (outside of infrastructure) and discretionary spending. Parts of the government will suffer too as the spending tap gets turned off.

Can we lift the anaerobic capacity of New Zealand?

The economy’s productive capacity is the combination of labour, capital, natural endowments and the efficiency of resources. It is the economy’s anaerobic capacity to grow without generating inflation.

The chief economist of the Reserve Bank noted a few weeks ago that “the productive capacity of the economy was lower than previously assumed”.

That is a fancy way of saying the economy has suffered extensive structural damage in recent years and we are poorer than we thought we were. It will take time to fix the structural damage. Roading is an example. 

Fixing something reduces time and resources to invest and grow something.

Geopolitics is the major variability. Geopolitical tension could exacerbate the persistence of inflation.

China and Taiwan. The US election. Gaza. Ukraine. What region is next? How seriously could democracy be challenged this year?

We live in a world where the rules-based system that we have been used to is being challenged by exercising power; the economics of trade is now morphing into the security of trade; and resilience is usurping efficiency with more just-in-case as opposed to relying on just-in-time. 

The International Monetary Fund’s October forecasts, titled Navigating Global Divergences, dedicated a whole chapter to fragmentation and commodity markets.

How do agriculture and the wider primary sector fit into all this?

Global demand conditions will be challenging, but we can take some encouragement from the resilience of dairy prices during China’s woes of late.

Agriculture is not construction, a sector with three gears: fifth, neutral and reverse. Food is an essential, though the more value-add components are more sensitive to economic conditions.

The primary sector’s productive capacity has been hit directly by a combination of costs, policy, and sustainability needs. Some can, and should be, corrected quickly, an example being ceasing requiring employers to pay regional seasonal employer (RSE) workers 10% above New Zealand workers.

But “carcinomic” takes you only so far and we need “growthnomics”.

Water has been noted by the government as a priority. We await the action.    

The geopolitical environment carries risk, but also signals opportunity. NZ needs to quickly define how it can take advantage of international needs for security in food and sustainability. Countries with less, or better managed food production cycle variability that can show sustainability credentials stand to benefit.  

The economic environment we are in is offering opportunities, and appetites to ask serious questions, and define solutions as opposed to kicking the can down the road.

An example is the inquiry into banking, which needs to go beyond retail banking. Banks price for risk but are they taking a lot compared to the alpha returns they have made in recent decades? We do not want irresponsible lending. But overly strict conditions stifle growth and innovation.

More lending into the productive part of the economy is a necessary part of the re-engineering of NZ, with our old growth model of selling more expensive houses to each other, relying on migration, and cheap imported products (boosting our term of trade) being exposed. 

The picks are in, and migration, inflation and fiscal policy are the three big issues for New Zealand in 2024 according to economists, as reported by the NZ Herald.

I’d put division at No 1 – and addressing it does not look easy.

The economist fraternity picks are the obvious ones through a conventional lens. Migration impacts housing, worker availability, inflation and infrastructure. Inflation siphons money out of pockets and higher costs hit business profitability. Restrictive monetary policy to tame inflation slows global growth, which impacts commodity prices. 

Fiscal policy faces a delicate balancing act, wanting to return to surplus, not crunch the delivery of services too much, address infrastructure shortfalls such as roading and deliver tax relief at the same time. Government-driven compliance adds to costs.

I will be watching infrastructure, an area where you can scalpel savings in the near-term, but under-investment eventually bites. 

The National Party’s track record on infrastructure is not good. I recently spoke to a teacher about education capital funding under the previous National Government. They only realised what they’d lost five years down the track.

If we are serious about the economy, building a better future, we need to own up, acknowledge and address division. Division is economically and socially corrosive.

The battles include young vs old, homeowner vs those aspiring, haves vs have-nots, landlord vs renter, rural vs urban, Māori vs non-Māori, respect/disrespect for the law and business owners vs workers. Division and a new government brought protests in December 2023, following protests against the previous government. I suspect there is a lot more to come in 2024.

The NZ election result was notable for the diminished vote for the political centre and growth of the political periphery. The two mainstream political parties captured around 65% of the vote, a sign the “centre” lacked vision and ideas.

“Fixing” migration is easy in comparison to bringing an economy and society together. To alter migration numbers, you just change the immigration settings or criteria.

My eyes are on the policy platform of the new government. The government continues to double-down on tax relief, a populist policy as opposed to a substantive one.

Uniting NZ is going to require astute leadership and a good policy. Good policy is not always the economically pure one.  A former minister of finance once told me the third or fourth best policy option was often the best one. It will stand the test of time and deliver certainty across the election cycle.

Living standards are built on an economic base. The past few years have seen NZ swing too far towards wellbeing, forgetting the economic base, as ideology ruled with limited appreciation of the destructive impact of adding costs. We cannot fly completely the other way, “fixing the economy” and letting social challenges lag, which is now a risk. No political party appears to get the balance right. Why index benefits to inflation yet superannuation to wages?

There is a gap in the political landscape.

We should be able to agree on the importance of kids and education across the political spectrum. Education is the foundation of the future. One in five Māori and Pasifika students attended school less than 70% of the time in the third quarter of 2023. Imagine work attendance of 70%.

Equality or equity of opportunity needs to be a strong focus. Māori and Pasifika kids do not get the same opportunity across education, housing, or health. Addressing inequities requires more funding.

NZ cannot turn the dial on global emissions but is prepared to play its part as a global citizen. The finger continues to be pointed excessively at farmers, though. Maybe (tongue in cheek) we need the urban equivalent of a farm management plan. Climate change is everyone’s responsibility, not just the major emitters.

The world is fracturing, and geopolitical tension is rife. Commodities are being used to exert pressure in conflicts such as in Ukraine.

NZ is hitching our wagon more and more in the United States’ direction. That potentially risks relations with China.

A divided world is not good for global growth or trade.

The coming year is notable for the huge number of elections around the globe, including in the US, Taiwan, Indonesia, the European Parliament and India. More than 60 countries go to the polls, around half the world’s population. We need real leaders, not populists. Unfortunately, the political periphery is gaining momentum.

Globally, rules are being challenged by exercising power. The economics of trade is being supplanted by security in trade, especially for food, energy and technology. That could provide opportunities for NZ. Onshoring, near-shoring and friend-shoring are replacing offshoring and globalisation as managing risk takes precedence over efficiency.

This is a world where supply shocks have been and will continue to be a regular feature. The latest pausing of shipping through the Red Sea, diverting around the Cape of Good Hope, adds to shipping costs. The past years have seen a “rolling maul” of supply shock after supply shock. 

Navigating division will be challenging, both locally and globally. It will require deft leadership and substantive policy, not populism policy. Eyes are on global elections and the policy prescription in the 2024 Budget.

Financial markets are taking a different view to that of central banks. Place your bets on who is right.

The former are taking the view that interest rates are set to come down over 2024 and 2025, providing much-needed interest rate relief. Market expectations are that the Reserve Bank of New Zealand is set to lower the Official Cash Rate (OCR) 100 basis points in the coming 18 months.

The yield on a NZ 10-year bond, after rising to 5.5% has, at the time of writing, receded to below 5%.

Contrast that with the Reserve Bank’s November Policy Statement, where it discussed raising the OCR and the prospect of it falling was a 2025 story. Other central banks, including the United States Federal Reserve, continue to express a willingness to raise interest rates further if needed.

The market is not buying into it. Central banks are done raising rates, and the more those expectations have firmed, it’s helped push up the NZ dollar versus the US dollar.

The drivers include favourable global inflation figures, which continue to nudge lower; and more signs of weaker global demand, and we can see evidence of that with oil prices dropping sharply over the past few weeks. 

Concerns towards China continue to linger, with Moody’s putting China’s credit rating on a negative outlook. Bad (economic) news has become good news for interest rates and borrowers.

NZ interest rate markets have become the two-bit player at the international roulette table and the bet is that if global rates are moving down, there is little reason to think NZ will be an exception.

Can we declare the war on inflation won?

We have seen lots of battle wins. Headline rates are receding around the globe. Recent falls in oil prices will help further, and some food items have fallen sharply in price of late. Slower global growth is helping dampen the ability to raise prices and open the prospect of discounting. Global supply chains have somewhat reconnected, freight rates fallen and geopolitical hot-spots that added to inflation, such as the Ukraine-Russia situation, have receded.

Wage inflation has started to moderate as unemployment rates have started to nudge higher. Inflation expectations – where people think inflation could be in a few years – have remained low, a sign central bank credibility is intact.

Central banks are more guarded. Some of that is tactical. As soon as you declare victory, markets will price in aggressive rate cuts, and central banks still need monetary policy to be restrictive to keep growth subdued to deliver low inflation.

While both underlying and headline inflation rates have decreased around the globe, they remain uncomfortably high.

The real inflation battle is not getting it from 7% to 4%; it is getting it from 4% to 2%.

Does it matter? With inflation at 2%, the price of an item will double in 35 years and price rises are barely noticeable. Inflation of 4% means prices double in 18 years and price rises feed on themselves with regularity.

With tight labour markets, wage inflation – while easing – is still inconsistent with low inflation, and adverse energy price developments are just one geopolitical shock away. The finger is being pointed at greedflation – firms expanding margins in some sectors.

Globally, central banks have had to face a rolling maul of supply shock after supply shock, which adds to the persistence of inflation. Powerful forces are seeing the global economy fracture as a rules-based trading environment is being challenged by exercising power, and security is now more important driving trade. NZ needs to redefine its trade strategy.

The latest International Monetary Fund’s economic assessment included a chapter on geopolitics and commodity prices.

Individual countries will have their own set of inflation circumstances that need to be wound into central bank expectations.  The first for NZ is migration, which is now adding to demand, rents and inflation. The second is the new government’s fiscal strategy. The Reserve Bank does not want to see demand stimulated further by more money being poured into the economy.

A key factor that will determine which nations navigate the tricky path towards getting rid of inflation is productivity.

It is the key to the holy grail. Less inflation without beating up the economy too much, prospective lower interest rates, and a big driver of profitability. ANZ’s Business Outlook Survey is hinting at it. Pricing gauges are inching slower, and growth expectations are up. Whether that is hope or substance is not clear.

Productivity is not one of those variables you can turn quickly, though. Education, infrastructure, skills, innovation, compliance costs, investment in the right assets, effective pricing and taking of risk, along with a host of other variables, are influential.

It will be up to firms and farmers to drive the first impetus to productivity via removing costs and, if possible, investing in technology. Consolidation is needed where good businesses take over weak businesses. This is not a cycle where bad businesses can expect to be bailed out by interest rate relief.

NZ is likely to lag countries such as the US, though, meaning we do the same on the inflation and interest rate front. 

A new government signals new direction and change. Sentiment has lifted.

Business confidence has risen to the highest level since mid-2017 with a net 23% of businesses confident about the economy according to ANZ’s Business Outlook Survey.

It’s almost as if a magic potion has been formulated in the past few weeks. 

General business confidence with the agriculture sector has risen to minus 12 (previous -44), the highest reading since mid-2021 and a big jump in a month.

Should we get excited? Beware the snake oil in magic potions. Business confidence is higher under a blue hue than a red one. There is a bias. Business confidence was negative every month under the previous government excluding four months (three of them when we bounced out of the first covid lockdown and the fourth in September 2023, the month prior to the election), and never rose above +10. 

Business confidence in the agriculture sector was positive for one month during the previous government’s entire tenure.

The economy did reasonably well with the unemployment rate sitting below 4% over an extended period though the fundamentals slowly eroded as costs increased and hit profits. Business confidence is a poor economic indicator not well correlated with economic performance.

Sentiment needs to be matched by substance. Ignore business confidence – but not the other questions in business confidence surveys. 

A net 56% of businesses in agriculture expect to be making less money over the coming 12 months compared to a net minus 6 for the wider economy. A net 40% of agriculture firms expect to invest less in their business compared to +4 for the wider economy.  Employment intentions are negative for agriculture. Lower profitability hits investment and employment. A net 64% of agriculture expect it to be tougher to get credit over the coming year. The economy-wide read is -21.

Any new government always blames the departing one for a host of problems. We will see a lot of that.

Inflation is a problem. Taming it requires pain. The Reserve Bank’s November Financial Stability Report points to resilience but also emerging stress. 

Within the inflation narrative, we focus too little on the impact of business. Costs ruthlessly undermine businesses/ farms and hit profits. The NZX50 is below where it was pre-covid. 

The Financial Stability Report states what we all know: “The agricultural sector is facing difficult economic conditions, owing to falls in dairy and meat prices, elevated operating expenses, and increased debt servicing costs.”

Both S&P and Fitch have endorsed New Zealand’s AA+ credit rating though. We can’t be in too bad a place overall and relatively better than a host of other countries. 

There is a big list of “to dos”. Top of list is getting a policy platform that can bring NZ a step together. Division – which we have – is both economically and socially corrosive. 

Next is battling inflation. Getting the Reserve Bank to focus solely on inflation and not a dual mandate of employment and inflation will not make a difference. The proposed tax relief package needs to be parked. Fiscal policy needs to be restrictive and help the Reserve Bank. Education, health, infrastructure and law and order require a lot of attention. 

NZ has the largest current account deficit in the OECD, signalling an unbalanced economy. Climate change policy needs pragmatism. We need more plumbers and fewer preachers in politics to get things done.

Steps to help improve profitability across the primary sector are essential. Without profitability, capital will not flow.

It would be folly for businesses and households to look to the government to provide all the solutions.

The seeds of the next economic upswing will ultimately be sown by businesses. Market signals such as currency movements provide direction. A low currency rotates growth from spending to earning.

Tough times bring appetites for change. Cost structures get analysed. Different ways of doing things identified. Good businesses take over poorly run businesses. Higher labour costs encourage substitution for technology and capital investment.

Discipline is returning. It started with the torching of Liz Truss, the temporary prime minister of the United Kingdom, and morphed into the United States losing its triple-A credit rating. Local authorities in NZ are having to address funding pressures, in some cases by selling assets. There is nothing like tough times to sharpen thinking and bring reality back to the table as opposed to ideology.

Tough times are an elixir for better productivity. Bad news, such as the demise of an entity, can ultimately be good if that entity is replaced, or gobbled up by a better one. That is an economy at work. We need to see that in action over the coming years.

The danger is that we reach for easy levers such as migration, take the dividend (growth) but fail to fund it properly (infrastructure, housing), and complacency sets in.

We need substance rebuilt into the growth equation, and productivity and innovation provide it.

“Back to basics” has been used as a political tag line, but it applies to households, farmers and businesses too.

The new government can help provide direction and will look for some wins. One could be major if we can secure a trade deal with India but beware the snake oil and political speak. 

It will take time to rebuild NZ’s economic base, but politics is full of short-term incentives. We need to see examples of the hard questions being asked, and steps taken. An example would be expanding the Commerce Commission investigation into banking beyond retail banking and into where banks make 60% of their profits.

Navigating Global Divergences was the title in the most recent World Economic Outlook from the International Monetary Fund.

The Ministry of Foreign Affairs’ 2023 Strategic Foreign Policy Assessment was titled  Navigating a Shifting World.

We now reside in a world were geostrategic and geopolitical considerations are front and centre. That creates uncertainty. The 30-year playbook on most of the world playing nice is being challenged by greater use of power usurping rules amid economic, and social division.

Such considerations are now manifesting at the level of interest rates. Uncertainty commands a risk premium, which is being accentuated by inflation’s persistence and rising concerns over government spending and debt issuance in the likes of the United States.

The backdrop could have profound implications on trade flows, but also absolute (export) and relative (export and import) price changes. New Zealand has been a beneficiary of the latter for the 30 years. 

Sub-par growth and a slow decline in core inflation were key messages from the IMF’s projections.  Inflation was not projected to return to target until 2025 in most cases. Forecasts for global growth over the medium term, at 3.1%, are at their lowest in decades.  

“Medium term growth prospects are weak, especially for emerging market and developing economies,” the IMF says.

“With lower growth, higher interest rates, and reduced fiscal space, structural reforms become key.”  

Which governments around the globe are going to lead, be bold, and who are going to play populists? We need the former. The New Zealand election was notable for a lot of populism propaganda.

While risks of a hard landing for the global economy have receded, the balance of risks remains tilted to the downside and the risks include China’s property sector, persistent inflation requiring higher interest rates and more climate and geopolitical shocks that could add to food and energy inflation. The IMF notes “little room for error on the policy front”.

All up, a fair bit of hope things will be okay, among lots of clouds.

Chapter 3 of the assessment focused on how geopolitical fragmentation and disruption to global trade in commodities can affect commodity prices and economic activity. 

According to the IMF, commodity markets are particularly vulnerable in the event of fragmentation.  Its model simulations suggest that trade disruptions could result in substantial economic impacts in commodity-dependent economies. Fragmentation can cause large price changes and create considerable volatility across commodities and thereby economic variability.

Post the Cold War, commodity markets have become more connected due to a range of reasons including trade liberalisation, technological innovation, and falls in transportation costs through supply chains. Integrated commodity markets have provided cheap inputs, particularly for manufacturing products, including the technological variety such as smart televisions, that have supported global growth and less volatility in growth.

Tradable or imported inflation (roughly one half of inflation) averaged around 1% per year in New Zealand and was low globally for a long time. A 2% target for inflation is not hard to achieve when half of all inflation is that low.

With the world fracturing and offshoring being replaced with near shoring, we are seeing profound shifts and security of supply is a key consideration. Many commodities are essential inputs for manufacturing and technologies covering clean energy, semiconductors and defence; and the availability can be concentrated in a few producers. Commodity production is hard to shift, though, as it reflects natural endowments (minerals), soil quality, or water availability and that creates dependence but also opportunities for those with endowments.

For 30 years, a defining tailwind for the NZ economy has been a profound relative price shift in our favour; the outperformance of export prices (food) relative to import prices (manufacturing), reflected in a 40% plus rise in the terms of trade. Better relative prices meant we needed to export less volume relative to import volumes to stand still.

The price of primary products outperformed manufacturing items; dairy products versus a computer, for instance, or a kilogram of steak versus a new television. Farmers focus on absolute prices. For the economy, it is relative prices that matter.

This relative price shift has deflected attention from weakness in productivity and per capita growth performance. 

Security is now an overarching theme. Security in food, energy, and the upland notes of technology. Chips control the computers and computers control the machines. Some essential commodities go into chips.

One of them plays into our strength, namely the production of food. NZ’s strategy needs to be far broader than targeting the likes of India for trade. That will help but we need a strategy that builds around the theme. The use of irrigation as an enabler of growth but also to mitigate production cycle risks is an example.

That is the absolute side of the equation.

The second side is the relativity. This side could be more problematic if relative prices shift in favour of manufacturing goods over primary products and reverses the 30-year trend. If so, it will be another signal of the need for sustained period of a weak currency.

Relative prices do not need to turn down. Even if they flatten out and we see export prices move in line with import prices so the terms of trade are flat, it removes an economic tailwind. Then attention will need to be more squarely on productivity and improving it will require a lot more than tinkering.

The rubber is now starting to hit the road. Economic reality is sinking in fast. Global and local interest rates are still moving up. At the time of writing the yield on a United States 10-year bond had risen to 4.6%.

Calls for a soft landing for the global economy and immaculate disinflation are wide of the mark in my view. Inflation is not going away without real economic pain. Most of the workforce has not seen real economic pain. You need to go back decades.

Geo-strategic issues are compounding inflation pressures with oil prices going from US$70/bbl to $90/bbl. Onshoring, near-shoring and friend-shoring are replacing offshoring. 

Just-in-time and efficiency are being usurped by just-in-case and resilience. 

Eyes are on industrial action globally as workers demand higher wages and the return of  benefits lost over the past decades.

This is not a central bank-friendly or immaculate disinflation world.

If inflation is the disease, higher-for-longer interest rates are the antidotes. The effects take time to diffuse across the economy. That argues for caution. Inflation’s persistence argues otherwise. 

Central banks are seeing some progress in areas where it’s needed.  

Falling business profits are being reflected in the tax take. The 2022 Budget projected corporate tax of $21.2 billion in the 2022/23 fiscal year.  The unaudited actual is $18.6bn. Corporate tax is projected to fall further in 2023/24. When firms make less money, attention turns to costs.

The number of people on a benefit is 17,000 higher than a year ago, now rising by around 800 per week though most of the uplift is not coming from those who are categorised as work ready.  That is an annual run rate of more than 40,000. Cue more social fracturing over the coming year, though.

Meanwhile, core inflation is still around 6%, barely budging in the past year.

Facing economic challenges, both the main political parties are backing migration. Better quality and settings will help, but the dividend from migration (growth) also carries a cost (housing, infrastructure and health pressure). The Reserve Bank cannot afford to let the housing market reflate and add to inflation pressure. You dent that with interest rates.

A complex web of cyclical and structural forces are now colliding. The playbook we have been conditioned to over the past 30 years is being challenged.

Navigating inflation presents growth and commodity price challenges. Interest rates look to be moving up not just due to monetary policy moving into a restrictive phase, but neutral interest rates (where central banks have the foot on neither the accelerator nor the brake) are moving higher too. The era of incredibly low interest rates is ending.

Geo-strategic and geo-political shifts are extensive and present both challenges (China versus the US, Russia) and opportunities (India, the Gulf Co-operation Council).

Artificial intelligence, climate change and the path to net zero, cyber security, demographic and digital transformation, rising demand for care and support services … the list of change is extensive.

I suspect we could see a major shakeout across management teams and boardrooms.

The election campaign has been notable for a lack of debate on key issues, one of which is New Zealand’s place and strategy in a rapidly evolving world.  Both main political party leaders have stumbled when asked about derivatives of a changing world, including China’s place and influence.

Every exporter and importer should read the Ministry of Foreign Affairs and Trade’s report Navigating a Shifting World. NZ has benefitted from open markets, founded on a trusted, rules-based trading system. That system is being challenged on multiple levels. 

Australia recently released an intergenerational report that noted: “Financial shocks, extreme weather events, the pandemic, malicious cyber activity and intensifying competition for resources such as food, water and critical minerals have further highlighted the importance of security and resilience for economic prosperity.

“Geo-strategic competition in the Indo-Pacific is rising – a major conflict would have far-reaching consequences for the Australian and global economy. 

“These events require unprecedented co-ordination between domestic and foreign policy and between economic and security settings to keep Australians safe and ensure our economic strength.”

NZ has a massive point of vulnerability with energy (diesel), but an opportunity with food and water.

The government needs to play point and lead NZ’s navigation through a shifting world.  I’m scratching my head thinking who the next trade or foreign affairs minister should be.

The rural community will be tested over the coming two years. Weak business models will be exposed. Good balance sheets will absorb poor balance sheets. Capital destruction is often needed to drive innovation and real change.

Do not go to banks with a problem ex post. Be on top of risks, how they will be managed, how the bank can help if risks manifest into reality, the support needed, and how they will be repaid. 

This is not a cycle where central banks look set to come to borrowers’ rescue as they did in the Asian crisis and Global Financial Crisis.

There are two overarching themes to remember. First, the recent economic expansion was unsustainable, and the coming decade will require a stronger focus on earnings-sector growth, with the primary sector an important cog, and a sustained lower currency helping. A change of government will not be a game-changer; businesses will need to adapt. 

Second, do not get weighed down by absolutes. Rather think about the coming years as a game of chess and our relative position in the production of food, and how we leverage nations seeking security in food supply as a point of advantage.