Day: September 12, 2023

Pretend fiscal policy and immaculate disinflation

Michael Reddell Fiscal policy, inflation

This morning’s post previewed PREFU at a high level, pointing out that both main parties had been in practice endorsing expansionary fiscal policy, and that the likely operating balance surplus that would be shown in the PREFU would really reflect nothing more solid than aspiration, even after the numbers had been gamed. Neither party seemed to have a concrete fiscal strategy or plan to actually close the deficit, a deficit which the IMF estimated a few weeks ago was one of the largest among advanced countries as a share of GDP.

As far as I can see there are no great surprises in the PREFU fiscal numbers. There is a small surplus in 2026/27, using the numbers the government told Treasury to use for its future spending plans. Anyone can plonk down a number. Delivering it is another thing.

There isn’t going to be lots of fresh analysis in this post, mostly (at least for fiscals) a series of charts I’ve shown on Twitter.

For example, here is how Treasury’s forecast of the operating balance (OBEGAL) as a share of GDP for the year we are now in has evolved just over the last 20 months.

The deterioration since the Budget this year is despite the economic position and capacity pressures (the output gap) being a bit less negative. This is a year for which the spending has now been appropriated, the taxes put in place etc.

What about the following year?

We aren’t anywhere that year yet, but the forecasts have already revised down massively.

And despite recent talk of renewed fiscal discipline and spending restraint, here are the projections for core Crown spending as a share of GDP, again for the next Budget year. The PREFU forecast share is higher again than the BEFU one. And this is before Ministers actually have to confront drawing up next year’s Budget.

The political parties want us to believe that we are on a track back to surplus. We aren’t. Instead, the Secretary has been given some numbers to be consistent with a surplus by the end of the period, and for anything else…..well, we just have to wait for successive Budgets under whichever government holds office.

As for Treasury, they have to be a little diplomatic, but here is their text about spending and operating allowances, and my summary commentary

The medium-term numbers in the PREFU are just not a serious contribution to anything much. They distract more than they clarify or reveal.

Whichever party forms the government they face tough choices over years if they were actually to be serious about getting back not to surplus, or even balance. If they aren’t serious then net debt will continue to rise as a share of GDP and within a few years we will have higher net debt as a share of GDP than the median advanced country.

I was also interested in the inflation and related numbers. Treasury is a bit more pessimistic than the Reserve Bank was in its last forecasts about how quickly inflation will come down. But they simply run with something like the Reserve Bank story of the OCR holding at current levels for some extended period.

There are odd aspects to that. For example, here is the inflation forecast to March 2025, 18 months from now – the sort of horizon monetary policymakers often focus on,

It is easy for your eye to focus on the fall in the inflation rate which, if it happens, will be a good thing. But note that 18 months from now annual inflation is still 2.7 per cent, well above the 2 per cent the MPC is supposed to focus on. All else equal, an outlook like that would normally suggest that further OCR increases were warranted. Treasury doesn’t show them, but then on OCR things they don’t really like being out of step with the Bank, and of course the Secretary to the Treasury, under whose name these forecasts are issued, is a non-voting MPC member herself.

But what is a bit puzzling is how Treasury thinks that the inflation rate is going to come down so much at all. The unemployment rate, for example, never gets beyond about 5.5 per cent and doesn’t even stay there for long. It took materially higher unemployment rates for several years in the last recesssion to get inflation to fall much less than is needed now.

And what of the output gap estimates?

Yes, the output gap is forecast to go materially negative but only for one year, and we see in these numbers nothing like the sustained large negative output gap of the early 2010s…..again when the extent to which core inflation fell was nothing like what is being sought this time.

By contrast, the Reserve Bank’s numbers from their latest MPS tell a more consistent story

It simply isn’t clear on what basis The Treasury expects core inflation to fall so far so (relatively) fast: core inflation is expected to roughly halve over the next year even though the output gap over the year to June is barely negative, and unemployment by next June is still only 4.8 per cent, barely higher than what Treasury seems to regards as a NAIRU.

Perhaps expectations will do the bulk of work. If you wish really really hard and truly believe then…..Treasury seems to say – you can have core inflation a long way down without anything too nasty economically along the way.

Perhaps…

(Finally, and incidentally, Treasury seems to assume some reasonably robust productivity growth over the forecast period. I’m not at all sure why, or on what basis?)

Previewing PREFU

Michael Reddell Fiscal policy

No doubt there will be a great deal of coverage of fiscal issues later in the day, once the PREFU numbers are out.

There will, no doubt, be lots of talk of possible operating surpluses years down the track. Little or no weight should be put on those numbers, which have in any case been gamed by the Labour Party in government (they tell Treasury what their policies – future operating allowances etc – currently are and Treasury simply represents that in their fiscal forecasts), and which represent aspiration rather than specific commitments and adjustments which would turn those stated aspirations into reality.

But even though both sides will no doubt utter pieties about getting back to surplus some time, both have been operating this year in ways inconsistent with such pieties. It seems safer to judge parties by their specifics (actions and immediate commitments) than by rhetoric about the medium term.

Labour is not necessarily making big specific campaign commitments now. That is because they already got their bids in in this year’s Budget, which was significantly expansionary (and not just because of one-off weather expenses).

Here was how the IMF saw things fiscal (based on actual policy, legislated in this year’s Budget) in their annual review of New Zealand published a few weeks ago.

Last year’s Budget had been expansionary too.

The IMF followed this analysis, in which they highlighted just how large the cyclically-adjusted primary deficit is, with the observation that while some post-cyclone stuff needed to be done the New Zealand authorities should aim for a “frontloaded fiscal consolidation”. In other words, cutting the underlying now……not several years down the track.

The IMF’s fiscal impulse estimate was very similar to The Treasury’s, as reported in the Budget documents in May

It wasn’t good fiscal policy, and it was operating directly in conflict with monetary policy, increasing the amount of interest rate adjustment the Reserve Bank had to do to get inflation down again.

We haven’t seen anything like a fiscal plan from Labour yet, but there have been individual policy promises. On the tax side, Labour wins the “mess up the tax system” award by paying for one policy (GST off fresh fruit and vegetables) which is abominated by pretty much all experts and will mess up a good tax (doing any good very inefficiently), by adopting another highly distortionary and inefficient tax (removing tax depreciation from non-residential buildings). But there don’t seem to have been any particular questions raised about the costings (and while there have been about the dental promises, they are years down the track).

So Labour’s approach to fiscal policy this year has been quite expansionary, worsening the fiscal situation and complicating monetary policy and the fight against inflation. Using the IMF’s numbers – but before whatever deterioration this afternoon’s numbers show – I ran this chart last week

We have, currently, one of the largest fiscal deficits of any advanced countries.

What of the main Opposition party, National? Opposition parties are at a slightly disadvantage in electoral auctions because governing parties, being the government of the day, get to legislate their excess first.

But National seems quite content to go along with that as the starting point. A couple of weeks ago they came out with their tax and spending plan (I wrote about it here). It claimed to be a fully-funded package that would not worsen the fiscal situation beyond what Labour had already delivered. Which would be bad enough: Labour runs successive expansionary budgets, dramatically worsening our underlying fiscal position, and National goes….well, that’s fine, we’ll just reorganise some tax and spending settings and not feel obliged to do anything about the deficit itself. They claimed at the time that they’d have a separate “fiscal plan” coming after the PREFU, but Luxon was quoted yesterday as saying that whatever was in the PREFU wouldn’t change anything about the (flagship) tax and spending plan released a couple of weeks ago. That isn’t really surprising (I pointed to this likelihood in my earlier post) and I guess now the question will be whether they bother announcing a “fiscal plan” at all. If they do, it seems unlikely to have any more substance than Labour’s pieties (an operating surplus by the end of the period, but no clue as to how concretely that might be delivered). Neither party in campaign mode shows any sign of actually cutting anything….. more a case of finding more relatively inexpensive baubles to throw at voters.

National also wanted us to believe that their fully-funded package would not add to demand and inflation pressures. As I noted in my initial post, that didn’t seem very likely, as the package delivered lots of people with high marginal propensities to consume, while being funded in substantial part from overseas house buyers (not, by construction, paying tax from New Zealand produced incomes).

But the actual situation is worse than that. No expert, no one who has looked carefully at the data or other relevant experiences, thinks that the proposed foreign buyers’ tax will raise anything like the $735m National expects year in year out (if there is pent-up demand perhaps it would get quite a bit closer in the first year (only), but not beyond that). The gap is quite large in the context of their package.

And so we go into the PREFU this afternoon, and whatever spin the two parties’ spokespeople are going to put on fiscal prospects with (a) a governing party that has already run up really big deficits, adding more fiscal expansion in their election year budget, with no specifics on how they might close those deficits (including in the face of ongoing cost pressures), and b) a main Opposition party which was seemed content to go along with Labour’s expansionary stance (just rearranging some of the tax and spending pieces), but in fact seems to have ended up with an even more expansionary stance themselves. (It doesn’t do to overstate the differences: the big picture is really large fiscal deficits and rising debt, which doesn’t seem to greatly bother either party, while the probable shortfalls in National’s package around the foreign buyer tax amount to an additional 0.1 per cent of GDP on the deficit each year. The additional credibility damage is probably greater than the fiscal damage.)

Finally, the debt. We have had 20 years in which New Zealand governments’ ran net debt as a share of GDP materially lower than the median OECD country. That gap is closing fast (this chart is using data well before the recent deterioration in New Zealand revenue flows).

And it isn’t a Covid thing. The point made by the chart is that the median country saw a brief Covid blip, but now has net debt as a share of GDP a bit lower than in 2019. In New Zealand, by contrast, by the big Covid spending well behind us, both parties seem okay with debt still rising rapidly (they may say otherwise, but judge them not by the handwaving medium-term rhetoric but by their specific and immediate actions and commitments.