New Zealand's economy slipped into recession in the third quarter, far worse than analysts had predicted, as economic activity shrank sharply and prior data showed even deeper contractions. The bleak results increase the likelihood of more aggressive interest rate cuts by the Reserve Bank of New Zealand (RBNZ).

The news shook the financial markets, sending the New Zealand dollar to a fresh two-year low of $0.5614. The currency has already declined by 2.2% as rising bets that the RBNZ will cut rates further in early 2025 mount. Markets now view a 70% chance of a 50-basis-point rate cut in February, with rates projected to fall to 3.0% by the end of 2025.

Data out Thursday showed New Zealand's gross domestic product fell 1.0% in the September quarter—the spectacular collapse compared with market forecasts of just a 0.2% decline. But that was not all, the previous June quarter was revised to show a 1.1% contraction. Two consecutive quarters of decline meet the technical definition of a recession.

Excluding the pandemic, this two-quarter slump marks the largest economic decline since 1991, a period remembered for its painful downturn.

"It was dramatically worse than anyone had expected," said Abhijit Surya, an economist at Capital Economics. "Given the dire state of the economy, we now think risks are tilted towards a larger 75bp cut in February. We’re more convinced than ever that the Bank will eventually cut rates below neutral, to 2.25%."

The RBNZ had forecast only a mild 0.2% decline, and New Zealand's Treasury had just this week expected a minor dip of 0.1%. The dreadful numbers, however, tell a far bleaker tale.

The recession comes at a time when New Zealand's government is facing major financial woes. Finance Minister Nicola Willis acknowledged the slowdown and lashed out at the RBNZ's policies, saying they were contributing to the economic downturn.

"The decline reflects the impact of high inflation on the economy," Willis said in a statement. "That led the Reserve Bank to engineer a recession which has stifled growth."

The government had already scrapped plans to return to budget surpluses, instead predicting deficits for at least the next five years.

Economic weakness was pervasive- manufacturing, utilities, and construction all fell sharply, and household and government spending declined as well. Investment and exports were additional drags on growth.

For the year through September, GDP contracted by 1.5%, much sharper than the expected 0.4% decline. Since the population increased by 1.2% over the same period, GDP per capita declined by an even sharper 2.1%.

Although the situation is grim, still, some analysts believe the economy may be turning around. Recent moves by the RBNZ to cut interest rates by 125 basis points have brought some relief; in addition, signs of improvement are emerging.

In the latest ANZ business survey, economic activity recovery for December was reported while business confidence held near historic highs.

"The survey showed more signs of demand recovering, with the first decent lift we’ve seen in past activity, which is the best GDP indicator in the survey," said Sharon Zollner, head of New Zealand economics at ANZ. "The bar for things to improve from here is clearly pretty low."

As economic conditions weaken at a pace faster than had been expected, the pressure remains on the RBNZ to take action promptly. There might be a case to consider deeper rate cuts in the coming months, as policymakers take necessary steps to revive growth and reduce financial stress from the household and business angles.