Inflation will remain high for some time and interest rate increases can't be ruled out, IMF warns

Wednesday, 14 June 2023

While inflation is falling it will remain high for a while, and if sustained could mean interest rates could rise or take longer to fall, the International Monetary Fund warns in its latest report card on the country’s economy.

The economy is likely to continue slowing in the near term as high interest rates take effect, the fund (IMF) says.

The Reserve Bank has rapidly increased the official cash rate (OCR) from 0.25% in September 2021 to 5.5% in earlier this month. As a result the economy has slowed but record low unemployment and high economic activity have kept inflation high and put upward pressure on wages, particularly in the services and construction sectors.

Annual Inflation peaked at 7.3% in the June quarter last year and slipped to 6.7% in the March quarter, still well above the Reserve Bank’s target range of 1% to 3%.

Most of the impact of the Reserve Bank’s interest rate hikes will be felt in this year and into next, the International Monetary Fund (IMF) says.

The rapid tightening of monetary policy is helping lower inflation. However, as non-tradable inflation, which mainly covers domestic goods and services, persists, there is little scope to lower the OCR for a prolonged period, the IMF says.

Increased demand, and inflation remaining above the Reserve Bank’s target range would require further tightening of monetary policy, the fund says.

It warns persistently high inflation and wage growth could compel the Reserve Bank to tighten monetary policy further, or keep rates high for longer, especially if the Government’s fiscal policy does not run to plan.

”In that scenario, tighter monetary conditions could have significant consequences for growth, household consumption, and house prices,” the fund says.

“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.

“Given the pressing capacity constraints and high and persistent inflation, the Government’s policy mix must strike a restrictive bias to rebalance the economy.”

It was also possible that rising net migration could potentially result in inflation reducing to the Reserve Banks target range faster than expected, the IMF says.

The Government’s “exemplary management of the pandemic”, allowed New Zealand to recover faster than most other advanced economies, the IMF says.

Financial support for businesses and households had resulted in strong investment and consumer spending.

“But this came at the cost of overheating against capacity constraints, exacerbated by restrictions on labour movement due to border closures, and disruptions in global supply chain.”

Migration has picked up sharply in recent months as borders have reopened and should help the worker shortages.

The current account balance has deteriorated significantly, reflecting excess demand and one-off factors such as extreme weather events.

The IMF says spending should be prioritised on the recovery from recent floods and Cyclone Gabrielle, while limiting other discretionary spending that adds to inflation

While the housing market appears to be stabilising, having fallen sharply in the past two years, housing affordability remains a concern, and boosting supply and expanding social housing are critical priorities.

“To that end, the recent increase in new housing is welcome and policy reforms to enable greater supply should continue.”

Despite the fall in house prices, the rental market remains tight and housing affordability, as measured by mortgage interest payments relative to income, has worsened, the IMF says.

“This, coupled with the strong capital and liquidity position of the banking system, helps contain financial stability risks.”

The addition of debt-to-income restrictions recently introduced will increase the Reserve Bank’s ability to deal with future financial stability risks, the fund says.

New Zealand’s banks are sound, with ample capital and liquidity levels, it says.

The IMF says tax reforms should be considered to best serve the New Zealand’s prospects including, over the longer term, the costs related to ageing, closing productivity gaps and investing in climate change-related priorities.

Superannuation reforms should be considered to deal with the challenges of funding pensions from current revenues while the taxpayer base shifts with the ageing population.

The IMF suggests well-designed tax reform could reduce corporate and personal income tax rates by broadening the tax base to include capital gains and land taxes, while also improving efficiency.

IMF mission chief Evan Papageorgiou​ told a media conference that at the heart of a capital gains tax was the “fairness an appropriateness of the tax system and how it is supposed to respond to the need for better and more durable growth”.

The issues of a capital gains tax, or a land tax, have been debated in the past but have not been progressed, Papageorgiou​ said.

“In our opinion, we feel that in isolation each tax measure has its own benefits and drawbacks, but overall revisiting the issue of how will the country rely on its long term revenue, is something that should be on the table and should be discussed.

“This can be done in many ways. It doesn't need to necessarily create or increase more taxes. New Zealand already collects enough taxes. It is a question of whether the configuration of those taxes goes to the heart of what New Zealanders want to see, in terms of how the government should serve them best.

Potentially that could also be done by lowering corporate taxes and personal income tax, and considering additional taxes that could make the tax system more progressive and fairer, he said.

“One could also make the argument that a land tax, or a land value tax done in a way that is more progressive could have the same effect as a wealth tax if it is designed in the appropriate way,” Papageorgiou​ said.