2017 Annual Report
As a small, open economy, developments beyond our shores have a large influence on New Zealand’s economic outcomes. After eight years in which the global expansion has struggled at times to gain momentum, despite unprecedented monetary stimulus by the major central banks, signs have been more encouraging over the past nine months. Growth is becoming more broadly based in the euro-area, business investment is picking up in the United States (US) and Europe and merchandise trade volumes are increasing, partly due to rising demand from China. While the major multilateral economic institutions forecast global growth to be around the trend rate of 3.5 percent in 2018, most consider the balance of risks to be on the downside. These include potential geo-political developments, stretched valuations in several asset markets and the rapid build-up in global debt.
With our own economy about to enter its ninth year of expansion, it’s useful to put a longer-term focus on New Zealand’s progress. Compared to the period 1990-2012 (i.e., the 22-year period since flexible inflation targeting was first introduced), New Zealand’s economy has experienced slightly stronger GDP growth and much faster employment growth over the last five years. Headline inflation has, however, been weaker and our current account deficit has been smaller as a share of GDP, while the unemployment rate has been around its average for the period since the mid-1990s. Labour productivity growth has been disappointing, a challenge we share with many other advanced economies.
While some of these economic outcomes since 2012 lie beyond the influence of Reserve Bank policy levers, the Bank’s monetary policy has been a significant driver behind the growth in output and employment. So too has been the pent-up demand for investment in construction and infrastructure, the rise in the terms of trade and the rapid increase in population.
Like other advanced economies, we share the challenges associated with subdued global inflation. The Bank has a medium-term target band of 1 to 3 percent for headline CPI inflation. Over the past five years, CPI inflation has averaged 1 percent, primarily due to the weakness of tradables inflation. During this period, tradables inflation averaged minus 1.2 percent, whereas annual non-tradables inflation, over which the Bank has much greater influence, averaged 2.3 percent. Underlying inflation, as measured by the Bank’s factor model, averaged 1.4 percent. It’s encouraging that long-term inflation expectations remain well anchored at the target mid-point of 2 percent.
In the year ended March 2017, the New Zealand economy grew 3.0 percent, and the unemployment rate fell to 4.9 percent, despite continued record immigration and historically high labour force participation. Annual headline inflation was 2.2 percent at March 2017, but this was pushed up by fuel and food price increases that are expected to be temporary. Annual CPI inflation was 1.7 per cent in the June quarter, and annual underlying inflation was running at around 1.5 percent.
The Bank is responsible for promoting the maintenance of a sound and efficient financial system. In recent years we have seen rapid house price inflation driven by population growth, low mortgage rates and constraints on housing supply. The combination of highly leveraged mortgage lending by banks and rapid house price inflation increased the financial stability risks facing the banking system.
The Bank responded by introducing, and subsequently adjusting, loan-to-value (LVR) restrictions that constrained high leverage mortgage lending. In this Annual Report, we note that tighter LVR restrictions on property investors from October 2016 have improved the resilience of the banking system. Since the introduction of LVR restrictions in 2013, the stock of high LVR loans across the banks’ mortgage portfolios has fallen from 21 percent to 8 percent.
Nationwide annual house price inflation has fallen from its peak of 21 percent in August 2015 to 1 percent in July 2017. The increase in investor LVR restrictions was one of several factors dampening house price inflation. Others included a rise in bank funding costs, a tightening in lending conditions by banks and concerns about housing affordability.
However, imbalances in housing continue to create risks to financial stability. Debt-to-income (DTI) ratios have increased in recent years. At the same time, house prices are high relative to income, increasing the risk that house prices correct sharply in the future, which could put heavily indebted households under stress. There would be flow-on effects on bank balance sheets and the broader economy. This is why we have been consulting on whether a DTI instrument should be included in the macro-prudential toolkit. We wouldn’t seek to use a DTI instrument while the housing market continues to moderate.
We also undertook substantial stress testing of bank loan portfolios, revised our outsourcing policy for banks, advanced the work around the publication of a quarterly dashboard for financial disclosure, and made substantial progress in reviewing banks’ capital requirements. We also laid the groundwork for a review of the Insurance Prudential Supervision Act 2010 (IPSA). In all of these initiatives, we were conscious of the need to ensure that regulatory interventions do not undermine efficiency.
This Annual Report outlines the Bank’s vision and strategic direction, our core functions, our eight strategic priorities for 2016-19 and the work programmes that flow from them. As well as outlining the environment we faced in the past year and our responses, it discusses success measures and assesses whether we met our goals.
Some important developments during the year are summarised below:
- To further our understanding of low inflation, both in New Zealand and internationally, we focused our research on: developing our understanding of consumer behaviour, especially in the context of movements in house prices; the impact of labour market dynamics, productivity and price setting behaviour; and the impact of changes in New Zealand’s external position.
- Results of the IMF Financial Sector Assessment Program (FSAP) were received in May 2017 and, together with other members of the Council of Financial Regulators, we have begun to assess how we might follow through on the FSAP recommendations. The Bank is considering closely the IMF recommendation that additional supervision resources are needed to implement the Bank’s current supervision model effectively.
- We improved our collection, analysis and publication of financial statistics. This included the publication of a new bank balance sheet collection and data from the new securities database. We also collected improved DTI data on residential mortgage lending.
- We completed the design of the Bank’s high performance framework and clarified roles and expectations for managers throughout the organisation. Better metrics were established to help managers assess their performance. Staff engagement continued to trend in a positive direction.
- On IT and business model development, we made substantial progress on the replacement of the Bank’s two payment systems, ESAS and NZClear, and on the implementation of the new Treasury Valuation System.
- A major project was initiated to assess the Bank’s currency operating model and supporting infrastructure, and to extensively review alternative approaches for the custody and distribution of currency.
- We extended our outreach programme, with 127 presentations around the country and overseas, and expanded the programme of on-the-record speaking, while maintaining a broad range of Bulletin articles, Analytical Notes and Discussion Papers. We increased our digital and social media engagement, including through additional video releases.
During the year the Bank continued to operate within its tight five-year funding agreement. After reviewing our space needs, substantial refurbishment work was undertaken in our Wellington building and three additional floors will be leased out.
I wish to thank the Board of the Bank for their intensive scrutiny, support and advice over the past five years that I have had the privilege of serving as Governor. The Board plays a critical role in monitoring the performance of the Bank and the Governor. I have been fortunate to work with three excellent and insightful Chairs in Dr Grimes, Dr Carr and Dr Quigley.
Above all, I wish to thank my colleagues in the Bank. It has been a great pleasure to work with my fellow Governors on the Governing Committee and with the Senior Management Group. The fact that the Bank continues to maintain a strong international reputation is due to the high calibre, dedication and commitment of colleagues throughout the institution.
25 August 2017