2008 Annual Report
Central banks are expected to steer a steady course, negotiating hazards like inflation, recession and financial stresses, so others can go about their business achieving economic prosperity. When these three hazards all threaten at the same time, both in New Zealand and internationally, we have a big challenge on our hands.
For some years we have been highlighting in our Financial Stability Reports the growing risks from cheap international credit, over-stretched economies, growing international imbalances, and the international housing boom. Many people have recognised this would be unsustainable, but few picked the trigger event for the correction. A year ago we started to hear about problems arising from the holders of financial instruments originating from US sub-prime mortgages. This quickly turned into a short-term credit crunch around the Western world, then into pressure on investment banks as they revalued their credit-based assets, and broadly into an increased cost of funding for all financial institutions.
Australasian banks have had little exposure to the sub-prime related credit instruments, but they are not insulated from the ultimate effects. There is a particular vulnerability in countries like Australia and New Zealand with low savings rates and a high reliance on foreign funding. The domestic situation has been exacerbated by the failure of many finance companies, especially some property development finance companies, which in turn has sped up withdrawals from some property and mortgage trusts, forcing freezes. Withdrawn money has flowed back into the banks as deposits. We believe the banking system remains robust, but some of the more peripheral parts of the financial system have suffered a lot. This has affected just over $5 billion of funds, much of which is frozen, but not necessarily lost. Serious as this is, it needs to be remembered that institutions not affected by these current events account for almost 90 percent of funds in the financial system. The vast bulk of the system – banks and others – are well capitalised businesses.
Tighter monetary policy through 2006/07 and 2007/08 and tougher international credit conditions have contributed to a rapid cooling of the housing and construction sectors. For years we have been warning of the risks in the way that some New Zealanders have invested in property and little else. Housing is looking extremely weak in the US and some other countries. It is not as bad in New Zealand, but the drop in housing activity and house prices together with more expensive mortgage funding is now hitting households. At the same time, shoppers are facing significant price rises, and these two pressures are depressing household consumption. Together with a drought earlier in the year, that has been enough to end the decade of uninterrupted growth.
Oil prices have been rising inexorably for the last four years, consistently topping expert forecasts, and continuing until recent falls. We have seen a parallel rise in mineral and industrial commodity prices, spreading over the last few years into food prices. This has been driven by a combination of supply, demand and regulatory forces, and we believe it contains both temporary and ongoing elements. This is bad news for New Zealand (the price of oil and industrials) and good news too (the price of dairy and other primary products). It is hard to invest and regulate wisely with such huge price movements happening, especially when they are confused by major (and related) swings in the value of the pricing currency – the US dollar. New Zealand businesses have coped reasonably well with this so far.
The upshot of all these price shocks is worldwide inflation pressure. Central banks around the world are increasing their CPI estimates month by month, which is a rather unpleasant phenomenon. We have had a similar such experience in New Zealand. The CPI has now been outside the target zone for three quarters, and will likely not return in zone till later next year. Compared with some other central banks we have one advantage: we have been running conspicuously tight monetary policy through the recent strong growth period, helping to anchor inflationary expectations and actions. We have room to continue to loosen monetary policy if we judge that is necessary
This has been a testing time for the 23 or so countries around the world that now use inflation targeting, an approach first formally applied in New Zealand. We now have two decades’ experience using it. What we have learned is that inflation targeting is not a perfect technique, that it may be offset by distortions in domestic or foreign markets, that its power should not be over-rated, and that it cannot achieve more than price stability. It is easy to make public criticisms of monetary policy. But we believe there is no better practical alternative available. The Reserve Bank and the New Zealand Treasury have been looking at improved ways to apply flexible inflation targeting in the New Zealand context. There are some possibilities, but they are not easy ones.
On a more positive front, we have been experiencing excellent dairy prices and there are signs of better prices for some other important commodities. These are big enough to make a major difference for us. When primary prices are high the country benefits. Beyond primary production, many businesses are facing a tough time, but the lower New Zealand dollar is beginning to help exporters, and the economy as a whole is much more flexible than it used to be, ready to take advantage of an international recovery when it comes. The various policy frameworks in New Zealand are still rated top class by international agencies.
We are a full-service central bank. That means we do monetary policy, bank supervision, payment and settlement services, currency, liquidity and foreign reserves management all in one building. In addition we maintain close relations with the New Zealand Treasury and other parts of Government. In principle, that means we are better placed than some of our offshore colleagues (where these functions are split) to identify economic-financial problems and do something about them.
I am pleased to be able to report that the Reserve Bank is in good shape to deal with current macroeconomic and financial stresses. We have been doing a lot of development over the past few years preparing for situations like this. These developments are described in this Annual Report. They include work to improve the robustness of the financial system: improved bank surveillance, better bank governance requirements, new Reserve Bank liquidity measures, minimum bank liquidity requirements, refreshed and extended payment and settlements technologies, stress testing, and new regulation planned for non-bank financial institutions and the insurance industry.
We are also using our Reserve Bank balance sheet in different ways. We have a new foreign exchange policy to help smooth peaks and troughs in the New Zealand dollar. In addition, we have built up a planned open foreign exchange position to give us more leverage in the event of severe volatility in the markets. We have a new capital injection from the Government, and have invested in a more sophisticated treasury management system.
We continue to develop our macroeconomic stabilisation tools. These now include a suite of data-driven forecasting models, and a new central forecasting and policy model, and we have done considerable work on the preconditions, effects and management of a slowing economy.
Because of the current difficult economic conditions, my introduction this year has focused on the preparedness of the Bank’s front-line operations. But none of this would work without the dedication and skill of our knowledge and IT teams, our finance and treasury units, our payment and settlement operators, our liquidity team, our currency operators and building and security support people, as well as others who do work in communications, human resources, risk and other support functions. The pressure is on and it is not an easy time for them, but I know they will deliver.
Thanks also to the managers and governors of the Bank for their energy, support and advice. Finally, to the Chairman and Board of the Bank whose task it is to monitor and advise us, our gratitude.
3 September 2008