Mission Concluding Statement 

New Zealand: Staff Concluding Statement of the 2023 Article IV Mission

June 13, 2023

Wellington, New Zealand:

Highlights

• New Zealand is likely to continue slowing in the near term as monetary tightening takes hold. Inflation is declining but will remain high for a while. The current account balance has deteriorated significantly, reflecting excess demand and one-off factors.
• Macroeconomic policies should retain a restrictive bias. Fiscal policy should prioritize the recovery from the floods and cyclone, while limiting other discretionary spending. The monetary policy stance is appropriate and should aim to bring inflation to target.
• The housing market appears to be stabilizing, though housing affordability concerns remain. Boosting supply and expanding social housing remain critical priorities.
• The financial sector remains sound with ample capital and liquidity levels. The RBNZ should continue to monitor financial conditions and calibrate macroprudential settings as required to maintain financial stability.
• Structural policies should aim at promoting durable and inclusive growth, particularly via tax reforms, innovative investment, infrastructure for climate resilience, and greater productivity gains such as for education and the labor market.

Slower Growth Ahead with Ongoing Uncertainty

New Zealand’s economy is in the midst of a necessary, policy-induced slowdown following the strong post-pandemic recovery. With exemplary management of the pandemic, New Zealand recovered faster than most other advanced economies. This supported activity and, together with generous fiscal and monetary support, resulted in strong investment, and private consumption. But this came at the cost of overheating against capacity constraints exacerbated by restrictions on labor movement due to border closures, and disruptions in global supply chains.Following significant monetary policy tightening, the economy is now slowing, but significant and persistent labor market constraints and the large positive output gap have kept inflation high.Labor market conditions remain extremely tight with record high labor force participation and historically low unemployment and underemployment rates. This has put upward pressure on wages, particularly in the services and construction sectors.

Policies have adjusted meaningfully.The Reserve Bank of New Zealand (RBNZ) was one of the first advanced economy central banks to tighten monetary policy in October 2021, and the official cash rate (OCR) has been raised by 525 bps to 5.50 percent.Following an expansionary fiscal policy in FY2021/22, spending moderated slightly in FY2022/23 due to winding down of COVID-related expenditures.

The external balance has deteriorated significantly.The current account deficit has expanded rapidly over the past couple of years to rise to 8.9 percent of GDP in 2022, fueled by a large output gap, strong domestic economy, and expansionary fiscal policy, coupled with one-off COVID factors that favored durable goods imports. At the same time, tourist and international student arrivals have been weak and are only now rebounding. The expected slowdown and rebalancing of the economy and the recovery in services exports should ease pressures, but careful monitoring is warranted.

House prices have corrected significantly but financial stability risks appear contained. The rapid decline in house prices reflects the reversal of the misalignment from the run-up during the pandemic, the cumulative effects of the substantial monetary policy tightening, and steps taken to improve supply, particularly in Auckland. Despite the decline, the rental market remains tight and housing affordability, as measured by mortgage interest payments relative to income, has worsened. Loan delinquency rates among households have increased, but they remain low for mortgages due to low unemployment and still-high levels of housing equity for the majority of borrowers. This, coupled with the strong capital and liquidity position of the banking system, helps contain financial stability risks. The recent addition of debt-to-income restrictions to the macroprudential toolkit is appropriate and will give the RBNZ more instruments to address future financial stability risks.

The economy is expected to continue slowing as monetary tightening takes hold . The bulk of the impact of the rate hikes will be felt in 2023 and 2024 given the usual lags in transmission. Growth is expected to slow to around 1 percent y/y in 2023 and 2024, with the possibility of a technical recession, despite some short-term boost from higher spending to address the North Island weather events and funding to meet central government cost pressures. Inflation is likely to decline gradually to the 1–3 percent target range only in 2025 given the pick-up in non-tradable inflation. With the border reopening, net migration has picked up sharply in recent months and should further alleviate labor market tightness, though the effect on net demand is unclear.

Risks to the outlook stem from the external environment and a potential need for stronger tightening of monetary and financial conditions . As a small open economy, global developments relating to growth, deepening geo-economic fragmentation, and financial stability shocks can significantly alter the baseline assumptions for New Zealand. Persistently high inflation and wage growth could compel the RBNZ to tighten monetary policy further or keep rates high for longer, especially if fiscal policy does not consolidate as planned in the forecast period. In that scenario, tighter monetary conditions could have significant consequences for growth, household consumption, and house prices. A severe version of this scenario could also have financial stability implications, given banks’ significant exposure to housing, high household debt, and borrowers’ vulnerability to rising interest rates. Upside risks are also emerging, with rising net migration easing labor constraints, potentially resulting in a faster-than-expected return of inflation to target.

Coordinated Policies and Reforms Can Deliver Long Term Prosperity

Careful calibration of policies is needed.Given the pressing capacity constraints and high and persistent inflation, the policy mix must strike a restrictive bias to rebalance the economy—internally and externally—and rely on automatic stabilizers to address the impact of slower growth. Over the longer term, fiscal policy will need to maintain an appropriate balance to address long-term structural needs such as preparing for the costs related to aging, closing productivity gaps, and investing in climate change-related priorities.To that end, there is a need to revisit the design of revenue measures via tax reforms that will best serve New Zealand’s long-term prospects.

• Fiscal policy should prioritize reconstruction efforts without unduly adding to demand. While the operating and capital allocations announced in Budget 2023 toward the weather events are necessary, the authorities need to further calibrate the fiscal stance to current economic conditions and limit discretionary easing that adds to inflation. Funding of cost pressures and new spending initiatives in the budget should be carefully executed to identify cost savings and limit the positive impulse in FY2023/24. The temporary reduction of the fuel excise duty should expire, as planned, on June 30, and current measures should be better targeted toward supporting vulnerable households, including by using more means testing. The planned fiscal consolidation over the next four years is welcome and should be preserved . Public debt sustainability remains robust and there is substantial fiscal space to address downside risks.
• The rapid tightening ofmonetary policyis appropriate and is helping lower inflation.However, as non-tradable inflation persists, there is little scope to lower the OCR for a prolonged period. A reignition of demand, including due to insufficient fiscal consolidation, and a stalling of inflation above target would call for further tightening of monetary policy.
• Financial stressfrom monetary tightening should be addressed through financial stability tools. The RBNZ should stand ready to provide liquidity if funding markets come under stress. With slowing credit growth and falling house prices, additional tightening of macroprudential measures is not called for at this time. The recent easing in loan-to-value restrictions is countercyclical and is not expected to add to demand but should be re-evaluated periodically.

Long-term fiscal challenges from large infrastructure gaps, climate change, and aging demographics underscore the need for strategic public investment in the medium term. Reconstruction needs following the floods provide an opportunity to strengthen resilience against natural disasters and climate shocks, while addressing infrastructure gaps. Policymakers must prioritize projects with respect to economic goals, address bottlenecks, and aim to deliver high value infrastructure, such as transport and those that facilitate housing supply. Reforms for superannuation should be considered to address the intertemporal challenges of funding public pensions from current revenues while the taxpayer base shifts with the aging population.

Housing affordability remains a concern, and efforts to expand supply must continue. Tepid signs of housing price stability are emerging. However, the cyclical downturn in prices does not imply that the structural housing shortage has been addressed. There is a strong need to expand housing supply, including for social housing to improve affordability. To that end, the recent increase in new housing is welcome and policy reforms to enable greater supply should continue. Achieving long-term affordability depends critically on freeing up land supply, improving planning and zoning, and fostering infrastructure investment to enable fast-track housing developments and reduce construction costs and delays.

Continued efforts are needed to meet greenhouse gas emissions goals. The decoupling of greenhouse gas emissions and economic growth continues, narrowing the gap between projected emissions and targets. However, the sharp decline in the emissions price is a concern as it could weaken the signal to the private sector to reduce emissions and lower the cash proceeds to the Climate Emergency Response Fund. The Emissions Reduction and National Adaptation Plans provide a useful high-level view of climate goals and targets and should be complemented with more detail to enable the prioritization of policies, including reforms to reduce agricultural emissions. If extended, the cuts in the fuel excise duty could result in higher demand for fossil fuels and leave emissions higher than in the baseline. Therefore, these measures should be allowed to expire as planned.

Structural policies and reforms should promote durable and inclusive growth . Revenue policy has a role to play in aligning tax collection with long-term economic priorities. A well-designed tax reform could allow for lower corporate and personal income tax rates by broadening the tax base to other more progressive sources, such as comprehensive capital gains and land taxes, while also addressing fiscal drag and improving efficiency. The authorities should continue to promote innovative investment and digitalization to support medium-term growth. Capital spending should aim at reducing the infrastructure gap and supporting the transition to a net zero carbon path. Tackling inequality should remain a priority, including through reducing barriers to education. In addition to improving education outcomes, boosting digitalization and the development of the information and communications technology sector can improve productivity. As the minimum wage has become increasingly binding after the rapid increase in recent years, further increases should be aligned with underlying labor productivity growth to avoid undue spillovers to overall wages.

The mission would like to thank the authorities and counterparts in the private sector, civil society, think tanks, and other organizations for frank and engaging discussions.