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Effective Monetary Stimulus: Measuring the stance of monetary policy in New Zealand

Michael Callaghan, Jamie Culling, Adam Richardson

The Reserve Bank of New Zealand sets monetary policy using the Official Cash Rate (OCR) as its policy tool to target price stability and maximum sustainable employment. However, the Reserve Bank’s monetary policy stance is also set by its communication of what might happen to the OCR in the future.

To set monetary policy appropriately, the Reserve Bank must assess overall financial conditions and their implications for inflation and employment. To do this, the Reserve Bank must take account of the range of interest rates at each borrowing horizon (i.e. the yield curve).

This is because how household and firms view the outlook for interest rates can also have an effect on today’s business activity, wage and price setting behaviour, and eventually inflation – it is not just the level of current interest rates that matters for economic activity and price setting. For example, a homeowner taking out a mortgage, or a firm taking out a loan, often borrow at longer terms and therefore consider current interest rates and the likely evolution of future interest rates when making decisions.

The Reserve Bank uses a range of tools to assess financial conditions in New Zealand. In particular, the Reserve Bank attempts to gauge how stimulatory or contractionary monetary policy needs to be to stabilise the economy. One tool to help in a broad assessment of monetary conditions – how stimulatory interest rates are – is the effective monetary stimulus (EMS) measure.

The EMS is a summary statistic that takes account of the (nominal) neutral interest rate and interest rate outlook. It provides a snapshot of the interest rates faced by businesses and households across the yield curve, and assesses whether these interest rates are stimulatory or contractionary for the economy.

The EMS is, of course, just one summary of overall monetary/financial conditions. The Reserve Bank also takes account of other influences when assessing overall conditions. For example, exchange rates, credit spreads, and uncertainty indicators are all monitored as part of the Bank’s policy assessment. It is that total assessment, rather than the EMS or yield curve alone, that is taken into account when considering the appropriate OCR setting to achieve the macroeconomic outcomes.

In this Note, we show how the EMS is constructed for New Zealand. We also show that the EMS measure is a useful indicator of the stance of monetary conditions. Lastly, the EMS measure also fits with the Reserve Bank’s narrative of the stance of monetary policy through history.