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In retrospect: Monetary policy in New Zealand 2017 to 2022

Titiro whakamuri kōkiri whakamua

This paper reviews and assesses the recent formulation and implementation of monetary policy in New Zealand.


The PDF was updated on 11 November for an editorial change. We removed 2 extra page breaks on pages 99 and 100.

What the paper is about

The paper outlines lessons learned from the operation of monetary policy during turbulent economic times and outlines our priorities for improving monetary policy going forward.

New Zealand’s monetary policy framework changed during the review period. The Government established a dual mandate in the Reserve Bank’s legislation, with the addition of ‘supporting maximum sustainable employment’ to the price stability objective. A formal Monetary Policy Committee and Remit for the conduct of policy were also established, replacing the previous ‘single decision maker’ model for the operation of monetary policy.  

The review period includes several years of significant economic volatility, initiated by the onset of the COVID-19 pandemic and accentuated by rising geopolitical tensions, including Russia’s invasion of Ukraine. When COVID-19 reached New Zealand in early 2020, significant health and social measures were implemented, to try and reduce the impact of the virus on New Zealanders. These measures caused disruption to economic activity for close to two years, with lingering effects, including labour shortages, still evident.

The global nature of the pandemic, coupled with pervasive health and economic uncertainties, created risks for the New Zealand financial system during 2020. The domestic and global financial markets that New Zealand’s commercial banks, corporates, and local governments rely on for funding and liquidity seized up in a way not seen since the Global Financial Crisis over a decade earlier. A sharp contraction in economic activity occurred in New Zealand and globally. In a highly uncertain global environment, the risks to future economic activity — both demand and supply —  were significantly skewed to the downside. 

In that environment, the Committee acted to ease monetary conditions by lowering the Official Cash Rate (OCR) to its ‘effective lower bound’ of 0.25%. The Committee also committed to keep the OCR at this level for the next 12 months. The Committee then implemented additional monetary policy tools (primarily Large-Scale Asset Purchases (LSAP)) to further lower long-term interest rates. Later in 2020, the Committee introduced the Funding for Lending Programme (FLP) to provide additional stimulus by lowering marginal bank funding costs, while also providing a funding backstop to ensure banks could maintain their liquidity and support customers. 

Government fiscal support to the economy was also incrementally and significantly increased over 2020. Unique support packages were designed and implemented at pace. The most impactful of these for household and business confidence was the Wage Subsidy Scheme. 

As a result, New Zealanders were provided with significant monetary and fiscal support during this period of high uncertainty, before a vaccine could be developed, approved and distributed.

While many domestic restrictions were eased by the end of 2020, ongoing changes to Alert Levels persisted as the virus mutated and spread. It was not until early 2022, with vaccine levels at target, that New Zealand effectively re-opened its borders to international travel. The isolation of New Zealanders —  both within and between borders — dramatically contained COVID-19 infection rates and allowed time for vaccinations to be available and distributed. However, the economic variability created by changing restrictions generated considerable supply and demand uncertainties for businesses and households. 

Despite significant disruption to economic output over 2020, domestic spending and exporting proved resilient. The combination of monetary and fiscal support, and the initial success in containing the spread of the virus in New Zealand, supported both domestic spending and employment — especially relative to the global economic outlook in early 2020. 

New Zealanders adapted to working and consuming from home. Spending patterns changed, with goods delivery growing strongly, while parts of the service sectors languished due to health-related isolation policies. Despite extreme volatility, New Zealand’s GDP over the 2020 calendar year declined by only a small amount and employment remained high. Statistics New Zealand recorded a 10% quarterly decline in GDP followed by a 14% quarterly increase over the course of the year.  

The aggregate economic outcome masks the significant variability in industry fortunes. Tourism, international education, and many service industries were severely impacted by the pandemic and are only now recovering. 

By early 2021, the economic outlook had improved due to reduced health restrictions, the vaccine rollout, and strong prices for New Zealand’s commodity exports. Low nominal interest rates had also spurred strong asset price growth, particularly in housing in New Zealand. House prices increased well above their sustainable level as the persistent shortage of supply struggled to meet higher demand.

Over the first quarter of 2021, in the face of ongoing supply-chain restrictions and an increasingly tight labour market, the Committee debated the extent to which rising inflationary pressures were likely to be ‘transitory’ or ‘persistent’. On balance, measures of core inflation and inflation expectations indicated that some inflation would be transitory.

However, the weight of persistent price pressures shifted significantly over the first half of 2021, resulting in the Committee signalling in its May 2021 Monetary Policy Statement (MPS) that the OCR would need to increase in coming quarters.  The Committee also reduced its level of bond purchases in the LSAP programme, before halting them outright in July 2021. The Committee also brought forward the expected timing of OCR increases into the September quarter of 2021. 

The arrival of the Delta variant of COVID-19 in New Zealand prolonged restrictions, particularly in Auckland, and spurred additional fiscal support. The timing of the first widely expected OCR increase was reconsidered when the country went into Alert Level 4 lockdown the night before the August 2021 MPS.

In October 2021, the Committee increased the OCR by 25 basis points. It was again raised by 25 basis points at each of the next two meetings, bringing it to 1% by February 2022. New Zealand was one of the first developed nations to commence a tightening cycle, with clear communication that significantly more tightening was to come. 

New Zealand house prices peaked in November 2021 and have steadily declined over 2022.  Higher interest rates, a house building boom, low population growth, and regulatory and tax changes all influenced the decline. 

From early 2022, domestic and border restrictions were progressively eased. However, COVID-19 became widespread in New Zealand for the first time since the pandemic began. And in February, Russia invaded Ukraine, accentuating global supply-chain constraints and inflationary pressures. 

The Committee raised the OCR in successive 50-basis-point steps from April 2022. It reached 3.5% by October 2022. The Committee also projected an OCR peak above 4% by early 2023. Annual inflation was 7.2% in the September 2022 quarter and is expected to decline back toward the target range over the medium term. Employment is estimated to be well above its maximum sustainable level at present and unemployment is expected to rise as domestic spending eases to better match supply.

The New Zealand economy has weathered the pandemic and war in Ukraine relatively well in international comparison. However, there are important lessons to be learned from the experience of the past 5 years. 

What the paper is about

The paper outlines lessons learned from the operation of monetary policy during turbulent economic times and outlines our priorities for improving monetary policy going forward.  

Our 9 key areas for improvement

1. Develop broader insight into the impacts of supply shocks on inflation

A deep understanding of the economic context in which monetary policy operates is essential. To this end, the Reserve Bank needs a strong focus on the supply side of the economy and the impacts of relative price shocks on aggregate inflation. Pandemics, earthquakes, and climate change are all examples of sources of shocks.

2. Develop new sources of data for economic monitoring

Committee decisions are based on an expectation of how the economy could evolve and how it will react to monetary policy decisions. There remains potential to incorporate more and different types of higher-frequency data into the Committee’s assessment process.

3. Develop better measures of neutral interest rates

Neutral interest rates fell more than expected in the period leading up to the pandemic, resulting in tighter-than-intended monetary policy. Improving our understanding of the stance of monetary policy (whether monetary policy settings are expansionary, contractionary, or neutral) assists in policy calibration. This includes improving our understanding of the factors that influence neutral interest rates and developing additional indicators of policy tightness.

4. Understand the future role of fiscal policy instruments in managing economic shocks

Working with Treasury, fiscal policy should also be considered as a source of stimulus under certain conditions, and/or when the OCR is near its effective lower bound. The recently-developed suite of fiscal tools need to be further understood.

5. Refine the measure of maximum sustainable employment (MSE)

The MSE objective in the Committee’s Remit is somewhat opaque and is not well understood by the public. Further clarity about its nature and how it fits within the Remit could be helpful.

6. Use LSAPs to mitigate financial market dysfunction

The LSAP programme was highly effective in response to the liquidity crisis that emerged in early 2020, when financial markets were becoming dysfunctional. As such, LSAPs should be used to correct dysfunction in financial market in future. Communicating the overall stance of policy while using a mix of policy instruments (OCR and LSAP) could also be improved.

7. Be cautious in providing forward guidance in uncertain times

To be effective, the FLP required a long time-commitment to ensure banks were confident that a stable and secure funding source was available. In hindsight, the FLP could have been designed with more flexibility. While forward guidance is effective, the appropriate stance of monetary policy is data-dependent.

8. Maintain the OCR as the preferred tool for setting monetary policy

The OCR is the preferred tool for managing the level of monetary stimulus through economic cycles, provided the OCR is above the effective lower bound. While AMP tools influence interest rates, they carry reputational risk as the general public only directly observe the marked-to-market fiscal implications of the Reserve Bank holding government bonds, as well as operational risk in calibrating their effectiveness.

9. Maintain operational readiness for AMP tools

The decline in neutral interest rates over recent decades increases the risk of the OCR hitting its effective lower bound. The Committee needs to maintain the operational readiness of AMP tools. This includes being able to implement a negative OCR if required.

The formulation and implementation of monetary policy has been consistent with its objectives. Over the past 5 years, monetary policy has been set to ensure that forecasts of inflation return to their target and maximum sustainable employment (MSE) is supported. However, while Reserve Bank forecasts have been relatively good compared to other forecasters, they misjudged some aspects of the New Zealand economy. For example, the fall in neutral interest rates prior to the pandemic and the effectiveness of fiscal policy during the pandemic were likely underestimated.

Monetary policy over the review period has had clear regard for the efficiency and soundness of the financial system. It has been set so as to avoid unnecessary instability in output, interest rates and the exchange rate. The Reserve Bank and the Committee have also comprehensively assessed the effect of monetary policy decisions on house price sustainability.

Faced with pervasive uncertainty, the Committee engaged in agile and nimble decision making in response to the pandemic. In early 2020, 3 monetary policy decisions were made over a four-week period, in response to a rapidly evolving situation. Likewise, Reserve Bank staff worked through operational matters in a systematic and considered way, leading to a well-controlled operational risk environment and well-implemented monetary policy decisions.

The dramatic easing in monetary policy was largely warranted during the pandemic, and worst-case economic scenarios were avoided. In the early days of the pandemic, the Committee eased monetary policy in the knowledge that there could be some ‘policy regret’ in future, depending on how the economy evolved. The Committee considered that managing future high inflation down, rather than dealing with deflation and economic depression, was likely to be the least-regrettable option. This approach was in line with many peer central banks.

The Reserve Bank’s forecasts and the Committee’s policy decisions are conditional on government actions. In 2020, new fiscal policy tools were designed and rolled out at pace. A clear understanding of the economic effects of these tools is key for monetary policy.

Additional Monetary Policy (AMP) tools were effective at restoring functionality to the financial system. The Committee’s response (along with other Reserve Bank actions) to the liquidity crisis in financial markets was highly effective, particularly given the environment of heightened uncertainty in early 2020. The LSAP programme successfully restored functionality to financial markets, and the FLP provided additional stimulus and supported confidence in the banking system.

AMP tools provided further monetary policy stimulus, as well as successfully addressing market dysfunction in conjunction with other liquidity measures. The LSAP programme put significant downward pressure on government bond yields and the exchange rate during the pandemic, while the FLP reduced bank funding costs and retail interest rates.

By providing additional stimulus, AMP tools contributed to higher-than-otherwise economic activity and inflation in the economy during the COVID-19 pandemic, consistent with the Committee’s objectives. However, with significant uncertainty over the strength of the transmission channels, it is difficult to accurately quantify the net economic benefits of these programmes. In contrast, the marked-to-market cost of the Reserve Bank’s holdings of government bonds bought under LSAP is relatively straightforward to measure.

The Committee’s inflation and employment objectives have not been in conflict over the review period. For instance, during periods when the inflation outlook has been weak, employment has not been above its maximum sustainable level. As such, the Committee has not faced a conflict in its objectives in setting monetary policy.

Prudential policy is the best way to limit financial stability risks resulting from the housing market. As house prices rose, the Committee recognised that, in most instances, any associated financial stability risks should be dealt with through prudential policy rather than monetary policy. Over the review period, the Reserve Bank has undertaken a large amount of research around the impact of monetary policy changes on house prices. In short, changes to interest rates result in changes to housing demand. If housing supply is sticky, then any change in housing demand will have an outsize effect on house prices.

Providing credible and clear communication are critical in monetary policy implementation. Clearly explaining and justifying monetary policy decisions is imperative in retaining credibility. Relatively stable long-run inflation expectations indicate strong Reserve Bank credibility. Some aspects of the Reserve Bank’s work, such as the requirement to support MSE, appears not to be well understood by the public. This suggests an ongoing need for strong communications.

Recognising the importance of being credible and consistent, the Committee kept the FLP in place as a source of funding for commercial banks until December 2022, as originally specified. However, because economic activity improved faster than anticipated, in hindsight, the FLP could have been designed with more flexibility. For example, the inclusion of an early termination clause with reasonable notice in the event of changed economic conditions could have been included, although such an amendment could potentially reduce the effectiveness of the FLP.

While monetary policy decisions have been consistent with the economic data available at the time, with the benefit of hindsight, it appears that monetary policy should have been tightened earlier in 2021. For example, the Committee could have supported an earlier tightening in monetary conditions by explicitly endorsing a lower volume of weekly asset purchases, reducing the overall size of the LSAP programme, and/or stopping the programme earlier. Likewise, in hindsight, the Committee could have raised the OCR earlier. Importantly, however, beginning the monetary policy tightening earlier in 2021 would not have fully offset the strong inflationary impulse stemming from a series of supply shocks, including Russia’s invasion of Ukraine.