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This is the Reserve Bank of New Zealand

July 2005

Also available as a PDF (349KB) and in hard copy format.

The overall purpose of the Reserve Bank is to maintain the stability and efficiency of the financial system. In this context, the financial system means the tools with which New Zealanders make transactions with each other and with the rest of the world.

Thus the Reserve Bank is required to ensure that, throughout the economy, money works as well as possible as a mechanism for making transactions, storing value, and keeping account. In this way the Reserve Bank provides a background environment which assists businesses and households to make their financial decisions. By doing this, we help to create the conditions for the strong, balanced economic growth that New Zealand needs.

The Reserve Bank's functions

The Reserve Bank has a range of statutory powers and functions designed to help maintain the stability and efficiency of the New Zealand financial system.

Price stability, inflation and deflation

Price stability means that prices overall are stable; in other words that money is holding its value on average. This does not mean that prices are frozen. On the contrary, in an environment of price stability we expect some prices to rise and others to fall. But on average, prices are generally stable.

By contrast, if prices move predominantly up or down on average, then we have inflation or deflation. In New Zealand, we have more commonly had inflation than deflation, and at times between the late 1960s and the late 1980s, inflation rose to quite high levels. If we have inflation, then the rise in the average level of prices means that money buys less. For example, the purchasing power of the New Zealand dollar has fallen by more than 90 per cent in the last 30 years. Most of that fall occurred before the mid-1980s, when inflation was often high.

Price stability is worth having because it protects the value of peoples' income and savings. It also means people can enter into business deals knowing that the prices set in a contract will mean essentially the same thing throughout its term.

Research confirms the common-sense proposition that inflation tends to go up when the general demand for goods and services exceeds the ability of the economy to sustainably supply them. Conversely, if the productive capacity of the economy is greater than demand, then the rate of inflation tends to decrease. Deflation can occur if that excess capacity is persistent. For virtually all of New Zealand's history, however, prices have tended to rise, and so when we think of price changes, we mostly think of inflation.

We measure inflation in New Zealand in a number of ways. Terms such as house-price inflation, food-price index, and other measures are all ways of measuring inflation in particular areas. However, the most widely used measure is the all-groups Consumers Price Index (CPI), which is calculated by Statistics New Zealand from price changes in a mix of goods and services purchased by a typical New Zealand household. Food, for example, has a 17 per cent weighting in the CPI; transport 17 per cent, personal and health care 8 per cent, and so forth. Because this 'basket' covers a wide range of goods and services, it is possible for an individual price to increase by much more than the CPI, but with only relatively minor effect on the final CPI rate. For example, petrol prices rose sharply during 2004 but, on average, the CPI did not increase by anything like the same figure.

Although New Zealand has more commonly experienced inflation, deflation can be just as damaging to an economy as high and variable inflation; indeed, deflation can be a sign that something is seriously wrong with the economy. This is why there is a floor to the inflation target, as well as a ceiling (see below).

Achieving price stability

The Reserve Bank achieves price stability through what is commonly called 'monetary policy'. This is targeted to achieve a particular outcome, defined in the Policy Targets Agreement (PTA) which the Governor of the Reserve Bank signs with the Minister of Finance. The most recent PTA, signed in September 2002 and reproduced on pages 14 and 15, requires the Bank to keep future CPI inflation outcomes between 1 and 3 per cent on average over the medium term. This means that inflation can and will move outside the 1-3 per cent range, perhaps on occasion for some time, but that looking ahead, 1-3 per cent is an anchor that people can count on in their planning.

It is important to know what monetary policy can and cannot do. As mentioned earlier, inflation will rise or fall if there is a difference between the overall demand for goods and services, and the economy's capacity to sustainably supply them. Monetary policy cannot affect the ability of an economy to supply. However, it can stimulate or dampen demand by adjusting short-term interest rates. This will affect, for instance, household decisions to borrow, or firms' investment plans. Adjusting interest rates helps ensure that inflation remains within the agreed band.

How monetary policy operates

Here's how the interest rate mechanism works. If you deposit a cheque in your account drawn on another bank, then that other bank must pay the money to yours. Hundreds of thousands of such transactions occur every day, and they result in a net debit or credit from one bank to another. These are settled up at the end of each day through the trading banks' settlement accounts at the Reserve Bank. The Reserve Bank undertakes to lend overnight cash to the trading banks at an interest rate 0.25 per cent above an Official Cash Rate (OCR); or to borrow overnight cash from the commercial banks at 0.25 per cent below the OCR. The OCR is set by the Reserve Bank, and is reviewed eight times a year. The effect of this is to constrain the commercial banks' own interest rates around the OCR. For example, if a trading bank offered short-term money at a greater rate than the OCR, it could be undercut by its competitors who would simply borrow from the Reserve Bank at a rate 0.25 per cent higher than the OCR. Over time, if people expect that the OCR will be held up (or down), this 'ripples' through into longer-term retail interest rates charged by the trading banks, such as term deposit, credit card and mortgage rates.

There are two ways this system influences inflation. The first is relatively indirect but powerful. Let us imagine that inflation is too high. The Reserve Bank increases the OCR, which allows the commercial banks to earn a higher return from their overnight cash deposits. Or, if they are borrowing from the Reserve Bank, they have to pay a higher rate. In such circumstances, the commercial banks may increase the 'retail' interest rates they pay and charge to customers, allowing savers to earn more from their deposits, while borrowers have to pay more for their loans. One result is that there can be less spending. Demand for goods and services can then return to the level at which the economy can sustainably supply them, and this helps to ease inflationary pressures.

There is also a more direct but typically less important effect. If people believe that the Reserve Bank will in fact keep inflation within the target range over time, they will modify their behaviour accordingly. In the late 1980s, before the Reserve Bank had fully demonstrated its ability to control inflation, many people were sceptical. As a result the Reserve Bank had to maintain higher real interest rates than it does today.

Foreign exchange intervention

The Reserve Bank holds and manages New Zealand's foreign exchange reserves. New Zealand has had a floating exchange rate since 1985, so that the value of the New Zealand dollar against other currencies has been set by the market. However, the New Zealand Government has resolved to retain a capacity, via the Reserve Bank, to intervene in the foreign exchange market to potentially reduce the peaks and troughs of the exchange rate cycle, or provide liquidity in a crisis. The amount of foreign exchange reserve held by the Reserve Bank is determined by the Minister of Finance. Intervention would involve buying or selling New Zealand dollars in exchange for other currencies, with the aim of restoring a smoothly functioning private market.

Banking supervision

Under the Reserve Bank Act 1989, the Bank is charged with "promoting the maintenance of a sound and efficient financial system; or avoiding significant damage to the financial system that could result from the failure of a registered bank". This means ensuring that registered banks operating in New Zealand behave prudently. All banks have to be registered, and the Reserve Bank operates a banking supervision system designed to reduce the likelihood of a bank collapse.

However, the Reserve Bank does not underwrite individual banks; and it does not provide a safety net for depositors in the case of bank failure. There is no Government-based deposit insurance or Government guarantee of deposits in New Zealand.

Under current regulations, registered banks must issue public disclosure statements four times a year. These must lay out in detail the state of each registered bank's finances, and considerably more information must be revealed than in the annual report of an ordinary listed company. Public disclosure statements are intended to warn depositors if a bank is at risk and, more importantly, to encourage bank managers and their directors to behave prudently in the first place.

The Reserve Bank of New Zealand Amendment Act 2003 introduced a variety of changes to the banking supervision regimen, including tightening the rules associated with the term 'registered bank', requiring Reserve Bank approval for any significant change of bank ownership, and streamlining the failure management powers of the Reserve Bank.

Currency

The Reserve Bank of New Zealand Act 1989 gives the Reserve Bank the sole right to issue New Zealand's bank notes and coins. The Reserve Bank controls the design and printing of New Zealand's currency and issues money to registered banks. The Reserve Bank also withdraws damaged or unusable currency from circulation.

Banks buy currency in wholesale amounts from the Reserve Bank at face value and return damaged or soiled bank notes to the Reserve Bank for replacement. The Reserve Bank is constantly on the look-out for counterfeit money. The introduction of polymer or 'plastic' bank notes in 1999 has made New Zealand's bank notes much harder to forge.

For more information on New Zealand's currency, refer to the Reserve Bank website, and the booklet Explaining Currency: New Zealand's bank notes and coins (PDF 398KB.)

Austraclear

The Reserve Bank also provides electronic clearing and settlement services using the Austraclear New Zealand System. This system provides real-time delivery and payment services for debt and equity securities. Members can also use this system to make large-value electronic payments. All securities in the Austraclear system are held on behalf of members by New Zealand Central Securities Depository Limited, which is a custodian trustee wholly owned by the Reserve Bank.

Reserve Bank Acts

The Reserve Bank operates under the Reserve Bank of New Zealand Act 1989. This Act provides the Reserve Bank with its statutory powers and obligations. As a result, the Reserve Bank is not a conventional government department or state agency, although it is fully owned by the Government.

The Reserve Bank Act gives the Reserve Bank autonomy in the way it achieves price stability. Previously, the Minister of Finance could direct the Reserve Bank to follow a particular policy without releasing the details to the public. Because of the 1989 legislation, this can no longer happen. The Minister of Finance can still change the objective of monetary policy via an override provision, but specific rules apply, including immediate publication. The Reserve Bank is also independent in relation to the management of overseas reserves, bank registration, currency design, and investment of the Reserve Bank's assets.

An amendment to the Reserve Bank Act in 2003 introduced measures designed to further strengthen the Reserve Bank's role in promoting a sound and efficient financial system.

The Governor

The Governor of the Reserve Bank is personally accountable to the Government for the Bank's performance, but in most areas the Governor has statutory independence as to how outcomes are achieved. There is no day-to-day ministerial involvement in, or responsibility for, most of the operations of the Reserve Bank. In terms of accountability, the Governor carries that burden alone. The Reserve Bank has a Board of Directors, appointed by the Government, but it is not a decision-making body. The Board's function is to regularly review the Governor's and the Reserve Bank's performance, and to provide feedback to the Minister of Finance. The Board makes recommendations to the Minister of Finance on the appointment or reappointment of the Governor, and, in extreme circumstances, can advise that the Governor should be dismissed for inadequate performance, especially in terms of the Bank delivering price stability. On monetary policy matters, the Governor is assisted by a committee system within the Bank. The minutes of those committees are not published because, although the Governor receives extensive advice, the final decisions are his alone. The Governor is then held accountable by the Board and the Minister of Finance. The Governor regularly appears before the Finance and Expenditure Select Committee of Parliament. He has an active public speaking programme and faces constant media scrutiny. The Minister of Finance appoints the Governor on the recommendation of the Board for a five-year term. Dr Alan Bollard became Governor of the Reserve Bank in September 2002.