Stable and sustainable macroeconomic environment

Overview

A stable and sustainable macroeconomic environment is an essential precondition for achieving the Government’s objective of growing per capita income. It allows individuals, businesses and the Government to plan more effectively for the longer term, thus improving the quality and quantity of investment in physical and human capital, and helps to raise productivity.

A stable and sustainable macroeconomic environment requires good fiscal management, good monetary policy and financial stability, as well as reliable information on fiscal and economic variables. Our role is to provide advice on macroeconomic and fiscal policy. We also provide timely and accurate economic and fiscal data, firstly through economic and fiscal forecasts and secondly through reporting the Crown accounts. In fulfilling these roles we work closely with the Reserve Bank, the Ministry of Economic Development (MED) the Inland Revenue Department (IRD), Statistics New Zealand and other relevant agencies for monetary and financial stability, and with all departments to ensure a sustainable fiscal position.

Our desired outcome contribution

• Advising on the economic impact and sustainability of fiscal policy in both the short and long term.
• Providing high-quality financial information that informs debate and analysis of fiscal policy.
• Monitoring the performance of the current Budget frameworks and developing options for revising them where necessary.
• Examining and, where necessary, refreshing our economic and fiscal forecasting processes.
• Further analysing the suitability of fiscal and monetary policy institutions to enhance resilience to domestic or international shocks.
• Further developing our understanding of cyclical and trend developments with respect to growth and other key macroeconomic variables.
• Increasing our understanding of the complementarities and trade-offs in anchoring inflation expectations, stabilising output and moderating fluctuations in financial and asset markets.
• Monitoring and advising the Minister of Finance on the Reserve Bank’s performance and working with the Reserve Bank to advise on monetary and financial policy, regulation and governance as appropriate.

Our progress

Economic performance

Growth in the New Zealand economy began to slow in the 2005/06 year. Growth in real GDP eased from 3.7% in the year to March 2005 to 2.2% in March 2006. Growth in real per capita incomes fell from 2.5% in March 2005 to 1.3% in March 2006. The main reasons for the slowdown were tighter monetary policy, lower terms of trade, lower net immigration and higher business costs. The slowdown was most apparent in the domestic sectors of the economy. Private consumption growth slowed from 5.8% in March 2005 to 4.1% in March 2006 and growth in residential investment declined from 2.3% in March 2005 to a contraction of 5.1% in March 2006. Net exports made a negative contribution to growth. The reasons were poor seasonal conditions for agricultural production, lower manufactured exports and tourism, and strong import growth due to consumption and investment growth.

Inflation, measured by the Consumer Price Index, was 4.0% in the year to June 2006, up from 2.8% in June 2005. The reasons were increases in international oil prices and the fall in the New Zealand dollar in the first half of 2006. Inflation in the domestic sector of the economy was also high with non-tradables inflation running at 4% or above for the past two and a half years. The Reserve Bank raised the Official Cash Rate a total of 50 basis points in two steps in the second half of 2005 to 7.25% and held it at that level in the first half of 2006.

The current account deficit increased sharply to 9.3% of GDP in the year to March 2006, up from 7.4% the year before. In the past year both the goods and investment income deficits continued to increase as a result of poor export performance combined with strong import growth, and servicing the large net negative international investment position.

The exchange rate declined sharply in the first half of 2006, falling 12% between the December quarter of 2005 and June quarter of 2006 on a trade-weighted basis. An expected continuation of this depreciation will help reduce the current account deficit by boosting demand for exports (particularly manufactured products and services) and curtailing import growth. Continuing high interest rates and the flow-through from past increases are expected to lead to a further slowing in domestic demand, particularly private consumption. Growth in real GDP is forecast to be only 1.0% in the year to March 2007 but to rebound to 3.3% in the year to March 2008 as a strong recovery in exports offsets continuing low growth in consumption. The lower growth and rebalancing of its components are expected to lead to lower inflation and a decline in the current account deficit.

Treasury contribution

In 2005/06, our contribution to this outcome centred on the provision of economic and fiscal forecasts and information on the performance of the economy. This information was contained in the Financial Statements of the Government; the Economic and Fiscal Updates, including a Pre-Election Update; and the Government’s Budget Policy Statement and Fiscal Strategy Report which included a revised long-term debt objective. We continued to support the systems and processes, and provided advice, for the preparation of the Government’s 2006 Budget.

The first Statement on the Long-Term Fiscal Position was published in June 2006 with the aim of making a major contribution to the quality and depth of public information and understanding about the long-term consequences of spending and revenue decisions. The Statement is a requirement of the Public Finance Amendment Act and must be prepared at least once every four years, incorporating projections of the fiscal position looking out 40 years. The major inputs to the model are the trend rate of economic growth and demographic projections, along with spending assumptions relating to superannuation and health care. The Statement helps to identify key decisions that will need to be made related to either fiscal objectives or levels of spending and revenue. Prior to the release of the Statement, the Treasury published a Policy Perspectives Paper setting out the methodology to be adopted for the projections. Following publication, the Treasury commenced a programme of wider communication to increase awareness of the pressures on New Zealand’s long-term fiscal position.

The Treasury carried out a review of the fiscal management approach in support of the Budget framework, implemented a new model for managing capital expenditure and implemented new processes for unappropriated expenditure, as required by the Public Finance Amendment Act.

The Treasury updated its regular analysis of its economic and tax forecasting performance and conducted an internal review and commissioned an external review of tax forecasting. The recommendations of those reviews are being implemented in order to achieve better forecasting performance. The Treasury also conducted a detailed comparison of its economic forecasts with other individual forecasters and the results were published as a Treasury Working Paper. A survey of users of the financial statements and forecasts was conducted to discover how they might be improved.

In 2005/06, the Treasury undertook further analysis of the resilience of the macroeconomy to domestic or international shocks. Reports were completed on the likely impact of a revaluation of the Chinese Renminbi. A Policy Perspectives Paper was published on the likely effects of an influenza pandemic on the economy, including the ability of macroeconomic institutions to cope with such an event. Research was also undertaken on the experience of countries moving from fiscal surpluses to deficits.

The Treasury also undertook analysis of the impact of cyclical and trend developments on growth and other key macroeconomic variables. Work commenced on the evaluation of different measures of trend growth and on developing a quality-adjusted measure of labour input in order to enhance our measure of labour productivity and multi-factor productivity. Work was completed on trends and determinants of the current account deficit and how the terms of trade have impacted on growth, the latter being published as a Treasury Working Paper. A Working Paper was also published which examined the contribution of fiscal policy to the business cycle.

The Treasury and the Reserve Bank cooperated on work on the stability of the macroeconomy in response to concerns about the effectiveness of monetary policy to curb high inflation, and the resultant high exchange rate and external imbalances. A report was prepared for the Minister of Finance in January 2006 examining Supplementary Stabilisation Instruments and a Forum was organised in June, which brought together international experts who delivered papers on different aspects of macroeconomic policy in New Zealand. The Forum concluded that our macroeconomic policy institutions are fundamentally sound, but suggestions emerged of ways to further improve monetary and fiscal policy. The proceedings of the Forum will be published. The Treasury also engaged with the Reserve Bank on the implications for gross debt and the Government’s debt programme arising from changes to liquidity operations management.

The Treasury’s work does not have a one-to-one impact on the key macroeconomic variables and institutions. Rather, the impact of our work was to:

• provide high-quality advice to the Minister of Finance so that he could make timely and informed fiscal policy decisions
• provide information to both the Government and private sector on actual and prospective economic and fiscal results, to help improve the basis for their decision-making
• continue to implement the objectives of the Public Finance Amendment Act 2004, in particular the publication of the first Statement on the Long-Term Fiscal Position
• prepare for the full implementation of the new international accounting standards from 2007. Implementing these standards will give enhanced credibility and transparency to the Government’s published fiscal information.

Challenges ahead

Although the core policies and institutions supporting the macroeconomic environment are considered to be sound, there will be a number of pressures ahead. Some of these relate to the reduction of high inflation and a large current account deficit. The context of slowing growth in the economy will place more pressure on fiscal policy in both the short term and long term. Our work will continue to focus on these issues, as well as:

• communicating the messages of the first Statement on the Long-Term Fiscal Position to a wider audience
• providing fiscal policy advice on fluctuations in revenue, expenses and aggregate balance sheet issues and reviewing long-term fiscal objectives
• providing advice on the overall macroeconomic framework and its operation
• monitoring, analysing and forecasting developments in the domestic and international economy likely to affect the nominal economy for purposes of forecasting tax revenue
• improving forecasts of tax and expenditure forecasts
• providing advice on the implementation of the International Financial Reporting Standards in 2007.