Economic Outlook for 1999 and Recent Financial Market Developments

2. Recent indicators suggest that the economic recovery that began in the third quarter of 1998 is continuing, and should unfold broadly as envisaged in the staff report. Consents issued for new dwellings have shown healthy growth in recent months, suggesting that the recovery in building investment is continuing. Credit to households has also picked up in tandem with the recovery in the housing market, but retail sales have remained relatively flat. Although agricultural exports remain weak as a result of the lagged impact of two consecutive droughts, exports of services (especially tourism) have increased strongly. The latest consensus forecast, released on August 9, projects growth of 2.5 percent in 1999, about the same as projected in the staff report (2.6 percent).

3. From its level at end-July, the New Zealand dollar has depreciated by about 2 percent, both against the U.S. dollar and on a trade-weighted basis. As a result of the lower value of the Trade-Weighted Index (TWI), the Monetary Conditions Index (MCI)—a weighted average of the TWI and 90-day interest rates—fell during August reaching about -350 on August 27, about 100-basis points lower than at the end of July. Long-term interest rates picked up from about 6½ percent in early July to nearly 7 percent in recent days. While this partly reflects higher bond yields in international markets, the yield differential between New Zealand and comparable U.S. bonds has also widened from 70-basis points in early July to about 100-basis points in recent days. This widening of the risk premium may reflect both concerns about the growing external imbalance, as well as political uncertainties in the runup to elections that must take place before year-end.

Monetary Policy Statement

4. On August 18, the Reserve Bank of New Zealand released its quarterly Monetary Policy Statement (MPS). In it, the Bank decided to leave the Official Cash Rate (OCR) unchanged at 4.5 percent. However, with the recovery more assured now than in May when the previous MPS was released and with the external environment facing New Zealand more robust, the Bank stated that the firming in monetary conditions needed to prevent the emergence of inflationary pressures would likely require an increase in the OCR before the end of 1999, somewhat earlier than had been foreseen in the May statement.

Tax Cuts

5. The government recently proposed a package of personal income tax cuts totaling NZ$400 million (0.4 percent of GDP) with effect from April 1, 2000. The main element of the package is a reduction in the middle personal tax rate from 21 percent to 20 percent and an increase in the threshold for the top income tax rate (33 percent) from NZ$38,000 to NZ$40,000. The government has not indicated how these tax cuts would be funded, but a paper on the funding implications is expected to be submitted to Cabinet in time for inclusion in the pre-election Economic and Fiscal Update. The legislation for the proposed tax cuts has not been presented to Parliament.

Staff assessment

6. The staff broadly endorses the Reserve Bank’s judgment on the need to bring forward somewhat the timing of a likely future increase in the OCR. The external environment facing New Zealand has indeed improved in recent months, reflecting upward revisions to growth prospects for 1999 in many Asian countries, Australia, and Japan. This is likely to give a fillip to the New Zealand economy and the staff sees some slight upward risk to its projection for GDP growth in 2000. The improved outlook should result in a somewhat more rapid closing of the output gap than was foreseen by the Reserve Bank in May.

7. At the same time, staff would urge the authorities to continue to monitor developments closely, and to keep an open mind on the appropriate timing of a future OCR increase. There continue to be risks that the recovery in Asia and Japan will encounter hiccups. In addition, while the Reserve Bank’s survey of expectations indicates some prospect of a pickup in wage growth in 2000, at present labor costs are showing only modest growth, and the latest consensus forecast does not foresee any significant pickup in labor costs either this year or next. Further, the rise in long-term bond yields, and the still fragile state of business confidence according to recent surveys, are likely to exert downward pressure on future demand growth, and hence slow somewhat the pace at which the negative output gap narrows. Therefore, to sum up, while the impact on New Zealand of the more robust external environment suggests the need to tighten policy earlier than previously envisaged, a number of other factors suggest the need to keep the issue of the timing of such a move under close review.

8. With regard to tax cuts, the staff supports the principle of reducing the direct tax burden in New Zealand (paragraphs 22 and 43 of the staff report). However, there is a need to safeguard the credibility of the authorities’ stated long-term fiscal goals and to prevent any potential weakening of market sentiment that could be engendered by a slowing of progress toward achieving those goals. In this regard, the staff has taken the position that tax cuts should not lead to any slippages in the envisaged paths of operating surplus increases or net debt reduction. While no decisions have been announced on how tax cuts will be funded, the staff would continue to underscore the importance of achieving at least as ambitious a path of fiscal consolidation as envisaged in the latest Fiscal Strategy Report.