Treasury paper warns more Government spending will hike interest rates

Interest rates are going up as the Reserve Bank tries to tackle inflation. Photo / Sylvie Whinray

Treasury warned that interest rates are likely to rise even higher if the Government increases spending beyond what it outlined in the Budget earlier this year.

A paper from Treasury to Parliament's Finance and Expenditure Committee on the subject of inflation said that if the Government's fiscal policy, meaning its settings around taxation and spending, "was to remain more expansionary than envisioned in the preliminary BEFU forecasts, interest rates would rise further than currently forecast".

Essentially, this means if the Government decided to spend more in the next few years than it forecast at the most recent Budget, it would trigger inflationary pressure that would require the Reserve Bank to hike interest rates higher than planned.

"Our rule of thumb for the impact of fiscal policy on inflation and interest rates is that an additional fiscal stimulus equal to 1% of GDP would cause the OCR [Official Cash Rate] to rise by an additional 30 basis points," Treasury said.

1 per cent of GDP is about $3.5b. The Reserve Bank will tomorrow review the OCR, currently at 2, with most economists expecting a hike to 2.5.

Officials said that in reality, the effects of government spending on inflation were more nuanced than just a straight correlation between the level of spending on inflation.

"Recent work at Treasury found that government investment and consumption tends to have the largest effects on domestic demand and interest rates," Treasury said.

"What has a smaller impact on interest rates are things like transfers, meaning changes to benefits and payments paid by the Government, and changes to the tax system, like tax cuts," Treasury said.

National's finance spokeswoman Nicola Willis said Robertson should have seen this advice, sent to him in March, and thought twice about spending money on things like the cost of living payment, which was pulled together in April for the Budget in May.

Robertson has said that the funding of the cost of living payment, which came from the Covid-19 recovery fund was not a net contributor to inflation because it came from money that was already set aside.

A regulatory impact assessment of the package warned it would "add to inflationary pressures in the short-term, although the risk to longer-term inflationary pressures is relatively small assuming any interventions of this nature were temporary".

The paper also carried a concession from Treasury that government spending during the pandemic "appears to have contributed to inflation". However it said that "Treasury stands by the advice provided at the onset of the pandemic to deliver a strong fiscal stimulus" - this is because the "consequence of providing too much stimulus was less than the consequence of providing too little".

National and Labour are currently locked in battle over the extent to which the Government's spending decisions triggered the current spike in inflation and whether it should start spending less to bring inflation under control.

The Government has argued that much of the current spike in inflation is not down to Government spending but the results of supply constraints in the post-Covid economy and disruption from the war in Ukraine.

Willis said the briefing showed the Government's spending was contributing to inflation and that Robertson should have spent less in the 2022 Budget.

"I found this incredibly vindicating - they're so explicit that inflation in New Zealand is not just the result of global factors and nor is it transitory.

"Grant Robertson has continued to say that this is because of Ukraine and Covid and this is a global phenomenon. They are explicit, 'a large part of New Zealand's inflation at present is driven by strong domestic demand'," Willis said.

She said this showed that Robertson's argument against the government spending being a significant cause of inflation did not totally align with what Treasury had been saying in private.

"It undermines the argument he has been making publicly," Willis said.

The effect of government spending on inflation is measured by the "fiscal impulse" which looks at the contribution that government spending makes to demand in the economy - a key driver of inflation.

The briefing, using figures published by Treasury at HYEFU in December last year, has the fiscal impulse for next year at about -5 per cent of GDP, while the figures published at the Budget in May had the fiscal impulse at -2 per cent of GDP.

This means that while the overall effect of Government spending on the economy will be to reduce inflationary pressure, the extent to which spending rescues that pressure was forecasts much less in May than it was in December.

"There's a big shift there," Willis said, saying that she was asking questions of the Government to justify why these figures shifted so much in the space of six months.

Treasury's own documentation published at the Budget makes the opposite point - saying that the "fiscal impulse for each year is slightly more contractionary than forecast" in December and that "overall, fiscal policy is dampening inflation pressures".

Treasury has not immediately clarified the apparent discrepancy between its text and its graph.

Robertson was not able to comment.

• For more from Thomas Coughlan, listen to On the Tiles, the Herald's politics podcast