The bill for New Zealand's strong Covid response is "coming due" and the economy now faces difficult headwinds, Westpac chief economist Michael Gordon says in a new quarterly outlook report.
Westpac has downgraded annual economic growth expectations for 2022 (from 3.8 per cent to 3 per cent), pointing to a slower comeback for tourism and hospitality coupled with higher inflation and interest rates.
"One of the biggest changes to our forecasts this time is that we no longer expect a pickup in tourism this year; self-isolation requirements will be too prohibitive for all but a handful of visitors," Gordon said.
"The issue is not the impact on the tourism sector per se. Rather, the total extent of demand pressures are shaping up to be less than we expected this year."
Combined with signs that higher interest rates were getting some traction in the housing market, and the risks around Westpac's forecast of a 3 per cent peak in the OCR were starting to look "more two-sided", he said.
But Westpac has lifted its forecast for annual GDP growth in 2021 - from 4.6 to 4.9 per cent, reflecting a milder impact from the Delta lockdown than initially expected.
"As we enter the third year of the pandemic, the price of New Zealand's largely successful approach to Covid is now revealing itself," Gordon said.
"A strong economic recovery, aided by fiscal and monetary stimulus, is running up against constrained capacity. As a result, inflation pressures are building up in a way we haven't seen for many years."
Gordon says blame should not be pointed at policymakers.
"Their aim was to err on the side of doing too much rather than too little, and they
deserve credit for achieving that – stubborn inflation is a better problem to have than stubborn unemployment ... but there was never going to be a cost-free solution to a shock of this nature, and the bill is now coming due."
New Zealand's situation was far from unique and "differed from the rest of only by a matter of degree", he said.
"Other countries are now waking up to the fact that they also have an inflation problem, and we expect to see several other central banks join the RBNZ in raising interest rates this year."
The Reserve Bank is widely expected to lift the official cash rate to 1 per cent - its third hike in a row.
Westpac forecasts it will need to keep hiking into the middle of 2023, lifting the OCR to 3 per cent.
While that forecast was unchanged from its November outlook, there were now downside risks to that view, including falling house prices and the slower rebound for tourism.
"New Zealand's elimination strategy was key to the strength of both our economic and health outcomes," he said.
"But as we transition to living with Covid, it seems that policy is struggling to move away from the 'elimination' mindset."
The Omicron outbreak was very different from previous outbreaks, he said.
"Notably, it is unlikely that we will see the sharp quarter to quarter swings in economic activity that we did when lockdowns were imposed in 2020 and 2021. Nevertheless, we still expect some significant economic disruptions."
The Omicron outbreak and related public health measures would dampen economic growth in the early part of 2022.
That was mainly because of softness in the tourism and hospitality sectors, although nervousness was also likely to weigh on both household demand and business spending more generally.
"However, while it's been a torrid start to the year, those Omicron-related disruptions are actually expected to be relatively brief. We expect demand to recover quickly as the peak in case numbers passes."
Meanwhile, the fiscal accounts have come through the pandemic in better than-expected shape.
That had given the Government scope to continue spending in areas like health and education to support its longer-term goals of enhancing social and economic well-being, as well as meeting its climate change targets, Gordon said.
"Even so, a period of fiscal restraint will be needed if the Government is to rebalance its books post-Covid."
Increases in Government spending were likely to be more modest over the coming years, with spending on public services growing at a slower pace than other parts of the economy.
"That means after providing a powerful boost to demand in recent years, fiscal
spending will also become a drag on growth over time," he said.