COVID-19 and the economy

The ups and downs, and everything in-between

In the early days of the pandemic, the very reasonable expectation was that locking down a hefty chunk of the economy for a couple of months would initiate a crisis of confidence, with firms shedding headcount and delaying investment, and households tightening their belts. It didn’t.

A cocktail of economic conditions

While confidence did fall off a cliff initially, it bounced back quickly and, in some cases, hit higher levels than before. The economic recession was sharp but so too was the rebound. The lockdown-sized hole in the economy was effectively put on the Government’s balance sheet for taxpayers to deal with another day.

It wasn’t just a fiscal stimulus. There was also monetary policy: interest rates were slashed, the money supply was rapidly expanded (via quantitative easing), and restrictions on investor lending were eased on the assumption that housing market confidence had been destroyed and unemployment would rise sharply. But household incomes have proven to be largely insulated, the labour market bounced back, COVID-19 was successfully contained, and most importantly, the fundamental undersupply of houses persisted. So all that cheaper and easier money culminated in a rather crazy pace of house price increases — as well as a significant shot in the arm for domestic demand.

Combine this stimulated demand with a reduced economic capacity to supply goods and services to meet it — as health restrictions limit labour supply and productivity globally, and as some capital and labour go into hibernation (such as that related to international tourism), we have ended up with a rather inflationary cocktail of economic conditions. Annual consumer price inflation threatens to touch 6% — a pace not seen since the 1980s (ex-GST). But we do expect official cash rate (OCR) hikes to take the pressure off in time.

The reality of the situation

Undoubtedly, the economy was in a very strong, albeit wonky, cyclical position heading into the current lockdown. With everything going to plan, that momentum should stick around on the other side, but the longer restrictions last, the less likely that will become.

Construction is booming and retail spending has been strong (despite lockdown impacts and supply shortages). However, there’s still a sizable national net income loss bubbling away in the background with international tourists still missing in action. Some hospitality businesses were barely standing on their feet again when the Delta strain of COVID-19 necessitated renewed lockdown measures.

Some businesses won’t survive to see borders reopen to vaccinated travellers once more. So far, we’ve filled the loss in aggregate income with copious amounts of household and Government debt. But it’s simply not economically sustainable to rely on that get out of jail card for long — debt carries a long-lasting legacy.

This time around there’s also a lot less housing-induced domestic demand waiting to be unleashed as soon as restrictions are eased. Rather, many previous housing market tailwinds are now becoming headwinds. Mortgage rates are lifting, loan-to-value ratio (LVR) settings have been tightened, affordability constraints are biting, the end of the QE-driven money supply impulse means credit conditions are tighter than previously, Government policy changes have taken the wind out of the sails of investor demand, and housing supply is catching up to demand.

House prices trends

New Zealand housing cycles are notoriously tricky to predict. But once they turn up or down, they tend to gather momentum quickly. We’ve pencilled in a soft landing for house prices from here, with annual inflation slowing into 2022. However, from such ridiculous levels relative to household incomes, a correction in house prices is a genuine possibility.

To help calibrate your thinking to how eccentric the market has been and get a feel for what a negative housing shock might look like, consider the 11% peak to trough fall in house prices that followed the GFC. The GFC erased a little less than 1.5 years of house price gains. If 1.5 years of price gains were erased now, prices would fall around 30%.

While significant house price falls are a risk, this is certainly not our expectation. For that to occur, we’d likely need to see a negative household income shock. But in fact, the labour market is very tight (in aggregate), and wages are growing. While many households probably are correct in feeling like they are going backwards (as consumer price inflation outpaces wage growth), that’s a markedly different scenario for the housing market to a weak labour market and rising unemployment.

Outlook

We’ve got a rough couple of months ahead with COVID-19, but high and growing vaccination rates provide a path forward. The growth drivers as we head into 2022 will be a different mix than in 2020 - 2021. Not only is the housing impulse fading, but the bulk of the fiscal impulse is also in the rear-view mirror, and monetary conditions are tightening.

However, households are in good shape overall and, if the labour market holds up as we expect, that’ll be a much more sustainable driver of economic expansion. With any luck, gradually reopening our borders to vaccinated travellers and diminishing supply bottlenecks over 2022 will be the cherry on top. As with everything in life, changing the recipe isn’t always popular with everyone, and it doesn’t always improve the end product. There are certainly lingering risks out there, but that’s the way the cookie crumbles.

Miles Workman

Senior Economist, ANZ