The government needs to keep its spending in check and the Reserve Bank ready to raise interest rates if necessary as the economy goes through a necessary slowdown, according to the International Monetary Fund (IMF).
In its annual health check on the country, the IMF said New Zealand's management of the pandemic had been "exemplary" but the economy had overheated because of the "generous" financial and monetary support, and was now going through a necessary slowdown caused by the RBNZ's rate rises to combat inflation.
"Macroeconomic policies should retain a restrictive bias. Fiscal policy should prioritise the recovery from the floods and cyclone, while limiting other discretionary spending," the report said.
It warned about the risks posed by the high current account deficit, which eased 8.5 percent of GDP in the first quarter showing the country living beyond its means, which it said needed monitoring.
The IMF also said the slowing housing market and rising levels of debt arrears raised risks for the financial system - although high employment and healthy banks would help limit the risks.
But it noted that housing affordability was a continuing problem, which falling house prices had not improved and which needed to be addressed by increased supply of new houses.
"Achieving long-term affordability depends critically on freeing up land supply, improving planning and zoning, and fostering infrastructure investment to enable fast-track housing developments and reduce construction costs and delays," it said.
The IMF expected the economy to slow further and possibly fall into recession, with growth of about 1 percent for the next couple of years.
The RBNZ's approach to raising interest rates to get inflation under control was given the thumbs up, and the IMF said that the official cash rate would likely have to stay high for a prolonged period, and possibly be raised again.
"A reignition of demand, including due to insufficient fiscal consolidation, and a stalling of inflation above target would call for further tightening of monetary policy."
For the longer term, the IMF said targeted government spending would be needed to tackle the challenges of climate change, an ageing population, and infrastructure gaps, including freeing up bottlenecks, and possible changes to superannuation.
It also revived its call for tax reform, including a capital gains tax.
"A well-designed tax reform could allow for lower corporate and personal income tax rates by broadening the tax base to other more progressive sources, such as comprehensive capital gains and land taxes, while also addressing fiscal drag and improving efficiency."