Why we undertook this work
As part of its monetary policy implementation framework, the Reserve Bank of New Zealand – Te Pūtea Matua (RBNZ) ensures that short-term FX swap-implied rates trade close to the Official Cash Rate (OCR).
As such, it is important to understand the macroeconomic drivers of the FX basis as well as the transmission of shocks to the short-term FX basis to key interest rate spreads that are considered important for broader financial conditions and monetary policy transmission.
The RBNZ is unique amongst peer central banks in targeting FX swap-implied rates for monetary policy implementation and the transmission of the FX basis has not been extensively studied within the global academic and central banking community. Therefore, our research is a novel contribution that will serve as a step towards greater understanding of how short-term interest rates transmit to the economy.
Summary
This Analytical Note presents results from empirical analysis of the drivers and transmission of the short-term FX basis in New Zealand.
We use Structural Vector Autoregression (SVAR) models to study the impact of shocks to macro-financial variables on the FX basis and the impact of shocks in the FX basis on interest rate spreads most relevant for monetary policy transmission such as mortgage rate and bank bill rate spreads. We supplement our analysis with Generalised Autoregressive Conditional Heteroscedasticity (GARCH) models to study the transmission of volatility in the FX basis to these same key interest rates.
These findings allow us to gain a better understanding of the role of FX swaps as a monetary policy implementation tool and serve as a step towards greater understanding of monetary policy transmission from short-term rates in New Zealand. Our findings may also help to inform how the RBNZ should respond to temporary movements in the FX basis, with a better understanding of the drivers and the consequences thereof.
Key findings
The short-term FX basis has several macro-financial drivers
We identify several economic and financial drivers of the New Zealand dollar FX basis, including shocks to the settlement cash level, the exchange rate and net offshore issuance. Some drivers – particularly shocks to the settlement cash level – exhibit persistent effects well beyond the initial days after the shock. Regulatory factors, including both onshore and offshore balance sheet constraints, also play a role.
FX basis shocks have some impact on key interest rate spreads
We also find that shocks to the level of the short-term FX basis have some impact on key interest rate spreads that matter for monetary policy transmission. However, the contributions are not large in the historical context.
Volatility in the FX basis transmits to volatility in key interest rates
We estimate a small but statistically significant pass-through of volatility in the FX basis to volatility in the Bank Bill Benchmark rate.