Monetary Policy Handbook

Chapter 1: New Zealand’s monetary policy framework and the duties of the MPC

1.1 Introduction

New Zealand’s monetary policy framework is set out in the Reserve Bank of New Zealand Act 2021 (the Act). The overall purpose of the Act (section 3) is to promote the prosperity and well-being of New Zealanders and contribute to a sustainable and productive economy.

The monetary policy framework is specified directly in the Act, and through three ‘secondary instruments’ that are provided for by the Act: the Remit, Charter, and Code of Conduct. This chapter describes New Zealand’s monetary policy framework and outlines some of the key requirements for the Monetary Policy Committee set out in both the Act and the secondary instruments, as well as broader supporting arrangements that have been established to support the framework.

1.2 The Monetary Policy Committee

Under the Act, the Reserve Bank has the function of formulating New Zealand’s monetary policy through the Monetary Policy Committee (MPC). The MPC consists of 5 to 7 individuals, comprising:

• the Governor
• 2 or 3 internal members who are Reserve Bank employees
• 2 or 3 external members who are not employees of the Reserve Bank.

Internal and external members are appointed by the Minister of Finance on the recommendation of the Reserve Bank Board and serve fixed terms.^1,2 MPC members are appointed on the basis of having appropriate knowledge, skills and experience to assist the MPC to perform its functions, and cannot be appointed on the basis of representing a particular industry sector.³

There is also a ‘Treasury observer’, an employee of the New Zealand Treasury, who can attend and speak at meetings of the MPC, but who cannot vote on monetary policy decisions. 

1.3 The MPC’s Remit, Charter and Code of Conduct

The MPC is responsible for formulating monetary policy to achieve and maintain stability in the general level of prices over the medium term. In doing so, it must meet the operational objectives in the Remit and act in accordance with the Charter and Code of Conduct.

In formulating monetary policy, the MPC is required to meet the operational objectives contained in the MPC Remit, and act in accordance with the MPC Charter and the MPC Code of Conduct. These 3 secondary instruments each serve a distinct purpose. 

1.3.1 The Remit

The Act provides the MPC with its high-level economic objective of achieving and maintaining stability in the general level of prices over the medium term. The Remit provides the MPC with more detail about how this high-level objective is to be defined or addressed – referred to as the ‘operational objective’. The Remit also provides the MPC with ‘secondary objectives.'

1.3.2 The Charter

The Act sets various requirements for the MPC with regards to transparency, accountability and decision making. The Charter sets additional requirements regarding these elements, and is divided into 3 parts:

• decision making
• transparency and accountability
• external communication.

The Charter aims to facilitate effective decision making by the MPC and ensure transparency of these decisions and the decision-making process. This is to aid the effectiveness of monetary policy and enable the public to hold the MPC accountable – the 2 goals of monetary policy communication.

Consideration and publication of diverse views

The Charter specifies that the MPC will seek to reach decisions by consensus, which refers to “a decision which all members can support” (section 1(b)). Consensus decision making is neither compromise nor unanimity, but rather supports the best interests of the group as a whole. This means that there is freedom to disagree, and that all views are aired and considered during the decision-making process. Chapter 7 of this Handbook sets out how the MPC might be able to achieve an environment that best supports this type of decision making. This style of decision making raises the question of how much of the debate to make public and whether, or how, to allow additional expression of diverse views.

There can be tension between the goals of MPC public communication and the expression of diverse views. In particular, greater transparency of different views behind monetary policy trade-offs and strategy could reduce the clarity of the policy signal to the market. In addition, dissenting views might reduce the credibility of the decision to some observers. However, there are also areas of alignment between the goals of MPC communication and the expression of diverse views. For example, portraying the diverse range of views behind policy strategy could increase the public’s understanding of the final MPC decision, increase the public legitimacy of policy, and improve the market’s assessment of how the balance of views in the committee is developing. Publicly communicating the views behind the policy decision could also prevent groupthink in the MPC to the extent it increases accountability.

Several clauses in the Charter specify how the committee should balance the expression of diverse views with the need to provide a clear and effective policy signal and ensure public accountability. It specifies that:

• Announcements of monetary policy decisions will be accompanied by a summary record of the MPC meetings, which will include a description of any material differences of view and judgement discussed (section 2(a)).
• The Governor is the “sole spokesperson” for the announcement of the MPC decision (section 3(b)). Having a single voice ensures that official announcements send a clear and effective policy signal.
• Public remarks by MPC members regarding the MPC’s strategy and decision are to “draw on the MPC’s official communications and on the Governor’s media conference remarks where appropriate”, and “notice of such communication should be publicly advised in advance on the Reserve Bank’s website” (section 3(c)).

The Charter also includes requirements around communications related to sensitive information:

• Any non-public remarks on monetary policy or the economic outlook should “avoid providing, or appear to be providing, new information to a subset of individuals” (section 3(d)).
• MPC members “must refrain from any public communications relevant to monetary policy following the receipt of MPC briefing papers and prior to the decision being announced” due to financial market sensitivities (section 3(f)). The period following the receipt of the MPC briefing papers and prior to the decision being announced is referred to as the ‘blackout period’.

Section 3(e) of the Charter also permits MPC members to publicly communicate their individual views on the MPC’s policy strategy and decisions, the balance of risks or the economic outlook. It mitigates the potential for reduced policy clarity by requiring that members provide an opportunity for the MPC to comment within a reasonable timeframe in advance of any public communication, refrain from characterising the individual views of other MPC members and express their views in a manner that shows respect for other members, the MPC as a whole, and the reputation of the Reserve Bank. The Charter also requires that notice of such communication should be publicly advised in advance on the Reserve Bank’s website. Prepared remarks or either a full transcript or the key messages from any such communication should be published on the Reserve Bank’s website alongside their release elsewhere.

Summary of key regular output required

The Charter requires the MPC to publish each monetary policy decision “promptly” on the Reserve Bank’s website (in practice, “promptly” is expected to be on the same day that the decision is made – discussed further in chapter 8). The Charter also reiterates the requirement in the Act that a summary record of each MPC meeting be published. The Charter gives additional requirements that these summary records of meetings are to meet.

They are to include:

• an overview of the economic outlook
• the main risks to the economic outlook
• the policy options discussed
• any material differences in view or judgement about the economic outlook, risks or policy decision; and
• an unattributed record of any vote taken.

On a quarterly basis, the announced decision is also to be accompanied by a Monetary Policy Statement (referred to in more general terms as “regular reports on monetary policy” in the Act). Section 130 of the Act requires every report to:

• specify the approach by which the MPC intends to achieve the operational objectives;
• state the MPC’s reasons for adopting that approach; and
• contain all other information required by the Charter.

The additional requirements for these regular reports are contained in section 2(b) of the Charter. Each report must also:

• explain how the MPC has sought to meet the requirements of section 2 of the Remit (the secondary objectives); and
• when applicable, explain why inflation outcomes and/or expected inflation outcomes are outside of the target range, explain the reasons for this, the timeframe over which inflation is expected to return to the target midpoint and the reasons for that timeframe.

The Reserve Bank, not the MPC, is legally responsible under section 129 of the Act for delivering regular reports of monetary policy. However, the Act also states that the Reserve Bank must ensure that the report is approved by the MPC before it is delivered (see section 1.5.1 for procedural responsibilities of the MPC).

1.3.3 The Code of Conduct

The Code of Conduct sets minimum standards of ethical and professional conduct for MPC members. The key elements include: 

• preparing for and participating in MPC meetings
• acting in the interests of the Reserve Bank, and not pursuing individual interests at the expense of the Reserve Bank
• declaring relevant conflicts of interest, or interests that could be perceived to be in conflict (some examples, such as currency trading, are discussed); and
• maintaining the confidentiality of information received in the course of being an MPC member, and never using that information or allowing others to use it for personal gain.  
  
   

1.4 Additional arrangements to support the framework

In addition to the Act and secondary instruments, several other arrangements support New Zealand’s monetary policy framework.

1.5 Evaluating MPC and the monetary policy framework

The Act includes several requirements relating to regular reviews of monetary policy and the MPC. These regular processes of review make sure the monetary policy framework remains fit for purpose.

1.5.1 Evaluating the MPC

In formulating monetary policy, the MPC is required to meet the operational objectives contained in the Remit, and act in accordance with the Charter and Code of Conduct. The MPC is held directly accountable for these responsibilities by the Reserve Bank Board. Section 99(1) of the Act states that:

For the purpose of performing or exercising its functions or powers in relation to the MPC, the board must regularly review the performance of the MPC, and each member of the MPC, in discharging responsibilities under this Act.

In addition, section 240(1) of the Act states that the Reserve Bank’s annual report must include “a statement as to whether, in the board’s opinion, the MPC and the members of the MPC have adequately discharged their respective responsibilities during the financial year” and a description of how the board has assessed this.

The responsibilities of the MPC and its members can be thought of as either procedural or performance-related in nature. The procedural responsibilities contained in the Act are for the MPC and its members to:

• approve regular monetary policy reports prepared by the Reserve Bank (at least four times a year) before the reports are delivered to the Minister (section 129(2)).
• be satisfied that those reports specify the approach by which the MPC intends to achieve the operational objectives and state reasons for adopting that approach (section 130).
• consider whether it is necessary or desirable to issue a replacement Charter when a new Remit is to be issued by the Minister (section 103(2)).
• have regard to any report produced by the Reserve Bank on a replacement Charter (section 103(3)).
• act consistently with the Act and MPC Remit and comply with the Charter and Code of Conduct (clause 40 of Schedule 3).

The performance-related responsibility of the MPC is to formulate monetary policy in accordance with the Remit, i.e. consistently with the inflation objective. Assessing whether the MPC has performed this critical task requires both ex ante and ex post approaches, as discussed in the following sections.

1.5.2 Review and assessment of the formulation and implementation of monetary policy

Section 131 of the Act requires the Reserve Bank to review and assess the formulation and implementation of monetary policy at least every 5 years. The Reserve Bank must deliver a report on this review and assessment to the Minister of Finance and also publish a copy on the Reserve Bank website. The Act also requires the Reserve Bank to ensure the MPC is consulted on a draft of the report. The first Review and Assessment of the Formulation and Implementation of Monetary Policy (RAFIMP) report covering the period from 2017 to 2022 was published in 2022.¹¹

Ex ante assessment of monetary policy

Monetary policy affects the real economy and inflation with a lag. This means that monetary policy must be set today in order to achieve price stability the future. Additionally, economic shocks frequently influence inflation outcomes and the MPC cannot (and should not) be expected to have perfect foresight. A fair evaluation of monetary policy decisions can therefore be based only on the information that was available to the MPC at the time.

For these reasons, a balanced review of the formulation and implementation of monetary policy hinges crucially on understanding the macroeconomic context that motivated decisions at the time they were being made. That is, just how reasonable were monetary policy decisions given the information available at the time?

In the context of the Remit, a comprehensive ex ante assessment of monetary policy in New Zealand might ensure that the following criteria have been met:¹²

• The forecast for inflation settles within the target band and near the 2 percent midpoint over the medium term (accounting for disturbances to inflation that are expected to be temporary in a manner consistent with meeting the medium-term target).
• The forecasts, especially for inflation, are credible and reasonable.
• The monetary policy decision and projected policy path are consistent with delivering these forecasts.
• The monetary policy decision and projected policy path avoid unnecessary instability in output, employment, interest rates and the exchange rates, relative to other policy paths that would also ensure the operational objectives are met.

Ex post assessment of monetary policy

As noted above, given that monetary policy affects the real economy and inflation with a lag, it must rely on forecasts of future developments to determine how policy should be set today. However, in addition to ‘real-time’ analysis, a balanced review also requires an evaluation of the appropriateness of monetary policy decisions based on the judicious use of hindsight. While hindsight should not be used to evaluate particular decisions made under very specific circumstances, it can provide broader lessons on the monetary policy framework and the broad appropriateness of decisions made within that framework.

Performance criteria for ex post assessment could include:

• Did the MPC respond reasonably to new information? If the Reserve Bank is responding to new information effectively, then there should be no systemic biases in its forecasts and the accuracy of those forecasts should compare well to other forecasters.
• Were developments communicated effectively?
• Was the credibility of the monetary policy framework maintained? Are the medium- to long-term forecasts for inflation and measures of inflation expectations credibly near the target midpoint?

1.5.3 Review of the MPC Remit

Under clause 2 of Schedule 3 of the Act, the Reserve Bank is required to provide advice to the Minister of Finance about possible changes to the Remit at least every 5 years. This ongoing process of review ensures that the objectives that guides monetary policy decisions best supports the economic wellbeing of New Zealanders, and remain relevant and fit-for-purpose in light of changes to the structure of the economy.

In the process of developing advice, the Reserve Bank must consult the MPC, seek views of members of the public, and consult the Minister on the scope of the Remit advice.

The first Remit Review was conducted in 2022-2023.¹³

1.6 Implementation of monetary policy

The MPC specifically is tasked with formulating monetary policy, which includes deciding the approach by which the operational objectives set out in the Remit are intended to be achieved (section 117). However, the Reserve Bank has the function of implementing the policy formulated by the MPC (section 120), a function ultimately governed by the Reserve Bank Board. For example, in the case of the Official Cash Rate – the Reserve Bank’s primary policy tool – the MPC decides the level that should be set at. The Reserve Bank’s Financial Markets directorate then implements the rate by factoring it into its activities in financial markets (see chapter 6).¹⁴  

Some monetary policy tools can involve financial risks to the Reserve Bank. Under section 121 of the Act, the Reserve Bank is not required to implement monetary policy formulated by the MPC if the Board considers that it would be inconsistent with its financial responsibility duties. These duties include ensuring that the Reserve Bank “operates in a financially responsible manner” and “prudently manages its assets and liabilities”. The Board sets out its approach to complying with this duty in its Statement of Financial Risk Management.¹⁵ 

Chapter 2: Monetary policy objectives – price stability and macroeconomic stabilisation

2.1 Introduction

The foundations of New Zealand’s current monetary policy framework were first put in place with the introduction of a formal inflation targeting framework through the Reserve Bank of New Zealand Act 1989 (‘the 1989 Act’) which came into effect in 1990. This chapter outlines the history of inflation targeting in New Zealand and describes how New Zealand’s monetary policy objectives have evolved in recent decades.¹⁶

Despite the evolution of the framework, including new legislation via the Reserve Bank of New Zealand Act 2021 (‘the 2021 Act’), there are a number of fundamental and enduring features of monetary policy in New Zealand that arose from the 1989 Act. This chapter also discuss the key beliefs underlying the monetary policy objectives the Reserve Bank has today.

2.2 Recent history of New Zealand’s monetary policy objectives

During the late 1970s and 1980s, New Zealand’s economy experienced persistently high rates of inflation, following a period of comparatively modest inflation during the 1960s. This experience generated a strong distaste for high inflation rates, with inflation regarded as a pressing macroeconomic issue that needed to be resolved with public policy. With many countries having experienced similar episodes of high inflation during the same period, economists’ understanding of inflation developed significantly through the 1970s and 1980s. The public’s attitude towards inflation, and the theoretical explanations for high inflation that were developed, set the stage for New Zealand’s inflation-targeting regime.¹⁷

Bringing high inflation under control was a key priority for the Labour Government that came into power in New Zealand in 1984. In 1986, the then Minister of Finance Roger Douglas invited officials to explore options for reforming the monetary policy framework. Prior to 1990, the monetary policy was directed at a range of objectives such as supporting production, trade, full employment and price stability, and the Minister of Finance had significant influence over monetary policy decisions. Politicians faced an incentive to use monetary policy to provide temporary boosts to economic growth and employment at the expense of long-term price stability and were often unwilling to face the short-term costs to output and employment that disinflation would bring with it.^18,19

The framework that emerged from the reforms – enacted through the 1989 Act – was the culmination of various strands of economic thought and the principles that were underpinning the wider reform of New Zealand’s public sector at the time. The 1989 Act formally recognised price stability as the primary objective of monetary policy, provided the Reserve Bank with operational independence to pursue its price stability objective, and made the Reserve Bank more accountable for its actions.²⁰ Under the 1989 Act, the Minister of Finance and Governor of the Reserve Bank agreed successive Policy Target Agreements (PTAs) which defined the inflation target for the Reserve Bank.

Following the introduction of inflation targeting in New Zealand, many developed countries also adopted explicit inflation-targeting regimes.²¹ The shift to inflation targeting was a significant factor in bringing inflation under control, following the high and volatile inflation prior to 1990.

In New Zealand, as with many other advanced economies, the monetary policy frameworks of the 1990s had a much greater focus on achieving low and stable inflation. However, as the Reserve Bank’s credibility in maintaining price stability built up over time, the framework gradually evolved to become more flexible. This enabled the Reserve Bank to consider other important outcomes, such as economic output and employment, in its pursuit of price stability. These changes were expressed through various changes made to PTAs and Remits over time. This general approach, referred to as ‘flexible inflation targeting’, is the prevailing monetary policy framework across advanced economies globally.

The legislation underpinning monetary policy has continued to evolve. In 2018, amendments to the 1989 Act brought about several changes to the framework, which were later carried through into the Reserve Bank Act 2021 (‘the Act’) as part of a wider review to update and modernise the Reserve Bank’s legislation. The 2018 changes included establishing the Monetary Policy Committee, replacing PTAs with monetary policy Remits set by the Minister of Finance, and introducing ‘maximum sustainable employment’ as an economic objective for the Reserve Bank in addition to maintaining price stability. Maximum sustainable employment was later removed as a primary objective through amendments to the Act and Remit in 2023.

2.3 Price stability as a primary objective of monetary policy

Since 1990, price stability has been a primary objective of monetary policy in New Zealand. This reflects that price stability is considered to be the best long-run contribution monetary policy can make to wellbeing.

Practical experience, in the United States and elsewhere, demonstrated that monetary policy can be an effective tool for restoring and maintaining low rates of inflation. For example, the policies of former Chairman of the Federal Reserve, Paul Volcker, are considered to have been instrumental in lowering US inflation in the early 1980s.²² While in the short run monetary policy can also be used to support other important outcomes, like economic output and employment, it is widely accepted that it cannot reliably do so in the long run – except, for example, through the benefits of price and macroeconomic stability.

The focus on price stability also reflects the damage that high or volatile inflation can do for the economy and the wellbeing of New Zealanders.²³ The consequences of inflation include:

• High inflation can distort price signals that embed important information about the scarcity and costs of different goods and services, and lead to resource misallocation. When inflation is high, such distortions can arise if certain firms or industries are slower or more reluctant to adjust prices or wages than others.
• Inflation can distort the tax system, leading to resource misallocation. As nominal interest income is taxed in New Zealand, higher inflation lowers real after-tax returns. This can affect people’s saving and investment decisions, particularly between assets where compensation for inflation is taxed (e.g. interest on bank deposits) and asset classes where it is not always taxed (e.g. capital gains on property and equities).
• In a progressive tax system, inflation can cause people to move into higher tax brackets and pay a higher marginal tax rate, even if their real income hasn’t changed.
• Unanticipated inflation can have significant distributional effects. By reducing the real value of debt, inflation redistributes wealth from savers to borrowers. It also reduces the purchasing power of people who have fixed nominal incomes.
• Higher inflation can make it more challenging for some people to service their mortgages, because lenders require compensation for inflation via higher interest rates. While borrowers benefit as inflation erodes the real value of the loan principal, the higher up-front interest payments can make it more difficult to obtain and service a mortgage.

Many of the consequences of inflation are exacerbated when inflation is extremely high or variable.²⁴ The same channels can also lead to distortions and distributional effects in the case of high or volatile deflation. For example, as with unanticipated inflation, unanticipated deflation has distributional effects, in this case by increasing the real value of debt and redistributing wealth from borrowers to savers.

2.3.1 Targeting low but positive inflation

Despite the costs of inflation, central banks have tended to target low but positive rates of inflation, such as the 1–3 % range specified in the current Remit.²⁵ One reason for this is that most measures of inflation, such as the Consumers Price Index measure that the MPC targets, have an upward bias and therefore slightly overstate inflation.²⁶ However, the positive target range also reflects a desire to avoid issues that can be exacerbated in an environment of low inflation, or deflation.

In particular:

• Firms and workers can be reluctant or slow to agree declines in nominal wages, even if demand for labour has fallen. This can lead firms to lay off staff or cut hours more than they would if nominal wages could adjust more flexibly. Inflation can help facilitate labour market adjustment, by allowing real wages to adjust lower over time to reflect supply and demand, even without changes in nominal wages. Deflation, on the other hand, can exacerbate the issue.
• Inflation can lessen the challenges created by the Effective Lower Bound (ELB) on the central bank’s policy interest rate. This is because higher expected rates of inflation allow central banks to achieve lower real interest rates for a given nominal rate.

2.3.2 Operational independence and an inflation target

Price stability has long been one of the stated objectives of monetary policy in New Zealand, even during the high inflation of the 1970s and 1980s. However, the institutional frameworks for monetary policy prior to 1990 did not always lead to monetary policies that were consistent with price stability.

In the 1980s, an important objective for monetary economics was to explain why inflation had become so high in the 1970s. One strand of the monetary policy literature argued that governments are innately predisposed to have an inflationary bias; they would ‘cheat’ on commitments to maintain stable monetary policy to boost economic activity in the short term. People would anticipate such cheating and act accordingly, and the consequence would be higher inflation with little real gain. Several solutions were proposed for this problem, chief among them an independent central bank tasked with price stability. Walsh (1995) provided a solution that involved assigning a contract to the governor of the central bank with payoffs that depended on the realised rate of inflation.

To some extent, Walsh’s research provided an ex-post justification for the inflation targeting framework that emerged in New Zealand with the 1989 Act. The 1989 Act appointed the Reserve Bank Governor as the monetary policy decision-maker, rather than the Minister of Finance. This ensured that short-term political pressures – often related to election cycles – did not influence monetary policy decisions.

This idea is referred to as operational independence – the freedom of decision-makers to conduct monetary policy without the influence of the elected government of the day.²⁷

Importantly, operational independence was combined with clear inflation targets specified through successive PTAs, and mechanisms for the government to hold decision-makers accountable. This allowed monetary policy to be formulated in a way that established – and then maintained – a high degree of price stability. This combination of operational independence, clear targets, and accountability mechanisms has remained a cornerstone of New Zealand’s monetary policy framework.

A key outcome of these arrangements has been to build the credibility of monetary policy in achieving the inflation target. In this context, credibility of monetary policy refers to the idea that the public holds a durable belief that monetary policy will achieve its objective of price stability.

If the public expects that the central bank will achieve its inflation target, this ‘anchoring of expectations’ around a published target makes it more likely that prices and wages will be set in a manner consistent with it, even in the face of shocks to the economy.

Given these benefits, maintaining credibility of monetary policy has been an important consideration in the successive reviews of PTAs, Remits, and the broader monetary policy framework that have followed the 1989 reform.

2.4 Price stability and macroeconomic stabilisation

The overarching purpose of monetary policy is to promote the prosperity and wellbeing of New Zealanders.²⁸ While price stability is considered monetary policy’s best long-run contribution to welfare, there is still scope for monetary policy to support wellbeing by reducing volatility in real macroeconomic outcomes such as output and employment. However, there are important trade-offs to consider.

2.4.1 The relationship between price stability and macroeconomic stabilisation

The short-run relationship between price stability and macroeconomic stability depends on circumstances in the economy and the nature of the shocks it faces. Demand shocks influence inflation and economic activity in the same direction. Because monetary policy works through demand, in the event of a demand shock it can simultaneously dampen the impacts on activity and inflation, albeit with a lag.

However, supply shocks push inflation and economic activity in opposite directions. This creates a trade-off for monetary policy, because responding to dampen the inflation impacts of a supply shock can exacerbate the impact on economic activity.

Taylor’s (1979) efficiency frontier  (figure 2.2) illustrates this trade-off by showing all the combinations of inflation and output volatility that monetary policy can achieve. The position on the efficiency frontier that monetary policy achieves depends on the weight the policymaker places on avoiding inflation volatility compared to output volatility.

Whether the point on the efficiency frontier is welfare maximising depends on the public’s preferences and attitudes across inflation and output volatility. Strict inflation targeting is only welfare maximising if the public does not care about output volatility at all.

When considering stabilisation of real macroeconomic variables, frameworks like Taylor’s tend to focus on output stabilisation, but the insights can also apply to other outcomes that are correlated with output, such as employment.

The Reserve Bank has sometimes referred to the guiding policy for achieving its mandate as its ‘monetary policy strategy’. Rumelt (2011) comments: “The guiding policy specifies the approach to dealing with the obstacles called out in the diagnosis [of the challenge]. It is like a sign-post, marking the direction forward but not defining the details of the trip.”

In the case of monetary policy, economic shocks that push inflation away from its target range and midpoint can be thought of as ‘obstacles’. The trade-offs that arise between achieving the operational objective and secondary objectives in the Remit are other obstacles. Therefore, monetary policy strategy can be thought of as an overarching approach that guides policy setting across the range of economic circumstances and trade-offs that are likely to arise.

Coherent actions are “feasible coordinated policies… and actions designed to carry out the guiding policy”⁴⁰. In the context of monetary policy, coherent actions can refer to specific decisions on the stance of monetary policy (that is, how stimulatory or contractionary policy should be) and the tactical approaches used to implement the strategy at each decision meeting (for example, movements of the OCR and forward guidance language).

3.3 Guiding policy: monetary policy strategy

Monetary policy strategy is the MPC’s guiding policy for how monetary policy will achieve its objectives, setting out how the MPC intends to factor in, or respond to, changes in the economy and outlook. A robust strategy should outline a consistent approach for making policy, as well as provide a consistent approach to weighing up the risks and uncertainty inherent in inflation forecasts.

A shared understanding and agreement between the MPC members about monetary policy strategy can assist with monetary policy deliberation, communication, and credibility.

This section discusses the Reserve Bank’s past approach to monetary policy strategy. We begin with the core principles that have underpinned this approach, before discussing the trade-offs between primary and secondary objectives, and how uncertainty can influence strategy.

3.3.1 Core principles of flexible inflation targeting

We first summarise two of the core principles that underlie the Reserve Bank’s understanding of flexible inflation targeting in New Zealand, which were also discussed in chapter 2:

1. low and stable inflation is monetary policy’s best long-run contribution; and
2. credibility of the policy targets is crucial.

The first principle reflects a widely-held economic theory that, in the long run, monetary policy can only affect the level of prices. Facilitating clear and predictable price signals can enable resources to be efficiently allocated in the economy and therefore support employment and output. Monetary policy cannot materially influence the long-run (or trend) level of employment, and therefore there is no trade-off between employment and inflation at long time horizons. However, monetary policy can influence cyclical movements in the real economy in the short-to-medium term.

The second principle reflects that the effectiveness of monetary policy relies heavily on the credibility of the Reserve Bank’s inflation target. If the public believe that the Reserve Bank has the will and the capability to manage inflation over the medium term, then they are more likely to behave in a way that helps to stabilise the economy. The importance of expectations means that the Reserve Bank needs to act and communicate in such a way that the public believes it has the will and capacity to achieve its mandated objectives. In turn, the public’s expectations largely depend on the credibility of the Reserve Bank’s monetary policy strategy and communications.

3.3.2 Key aspects of the Reserve Bank’s historical monetary policy strategy

Inflation forecast targeting

Historically, the Reserve Bank’s monetary policy strategy has generally been to choose a policy stance that is expected to result in inflation reaching the target mid-point after about two years. The time to target has been allowed to vary to reflect consideration for the Reserve Bank’s secondary objectives. The typical timing of about two years reflects the view that a monetary policy decision today is fully transmitted through the economy after about two years.

This approach is referred to in the monetary policy literature as inflation forecast targeting – the central bank sets policy so its inflation forecast is at target.

Symmetry of policy targets

In the past, the Reserve Bank has treated its policy target (inflation, and previously also maximum sustainable employment) as symmetric. In other words, deviations above and below target have been treated, and responded to, in the same way.⁴¹ The specification of the inflation target, in terms of a target range with a focus on the mid-point, implies a symmetric approach.

A symmetric approach to inflation helps to anchor inflation expectations at the target mid-point, improving the effectiveness of policy.

3.3.3 Flexible inflation targeting trade-offs

The Remit requires the MPC to take into account several secondary objectives (see chapter 1). This section will explain the trade-offs that may occur between the inflation objective and secondary objectives.

Specifically, in pursuing the inflation objective in the Remit, the MPC must consider how secondary objectives should be traded off against the inflation objective when a change in the monetary policy stance would improve outcomes for the inflation objectives, but worsen outcomes for the secondary objectives (or vice versa).

(i) Have regard to the importance of protecting and promoting the stability of New Zealand’s financial system

As discussed in chapter 1, monetary policy can have important implications for the stability of New Zealand’s financial system. Prudential policy, including macroprudential policy, is the Reserve Bank’s main tool for supporting the stability of New Zealand’s financial system. However, there may be situations where it is optimal for the MPC to reflect financial stability considerations in its formulation of monetary policy, while still pursuing the inflation objective.

For example, the MPC might use monetary policy to help lean against risks to financial stability (for example, those arising from rapid growth in credit and asset prices), as long as doing so does not compromise the operational objective in the Remit.⁴²

(ii) Avoiding unnecessary instability

Section 2(b)(ii) of the Remit also requires the MPC to “seek to avoid unnecessary instability in output, employment, interest rates, and the exchange rate”. The consideration for stability in economic output, employment, interest rates and exchange rates is fundamentally about how quickly the MPC intends to meet its inflation objective.

There are several trade-offs in this decision, and these trade-offs are likely to differ depending on economic circumstances. The MPC could meet its target faster at the cost of creating more volatility in the economy and interest rates. Or the MPC could meet its target more slowly, with the cost of more-prolonged deviations from the inflation target and the risk of inflation expectations becoming unanchored.

The requirement to avoid unnecessary instability in the macroeconomy has been a key consideration behind the Reserve Bank often setting policy with the aim of returning inflation to the target mid-point over a period of time, such as within two years, and allowing this time horizon to vary depending on the shocks hitting the economy.

The MPC Charter requires the MPC to explain the timeframe inflation is expected to return to target, and the reasons for that timeframe, in the Reserve Bank’s quarterly Monetary Policy Statements.

If the MPC tried to return inflation to target as quickly as possible, then this would result in higher economic volatility and large interest rate adjustments. Interest rate changes take time to have their full effect, so larger changes in interest rates would be required to return inflation to target more quickly.⁴³ Increased volatility in interest rates would result in undesirable volatility in output, employment, and the exchange rate.⁴⁴ Therefore, the Reserve Bank has previously interpreted this clause to mean that monetary policy should be formulated such that there is no alternative interest rate path that could improve stability, subject to the operational objectives being met.⁴⁵

Conversely, if the MPC maximised interest rate stability and chose an interest rate path such that it would take a long time, such as five years, to return inflation to target, it would also face costs. Firstly, the operational objectives would be deviating from their targets for longer. Secondly, the longer that the Reserve Bank allowed inflation to deviate from target (and did not show a credible plan to return it to target), the more likely it is that inflation expectations would become unanchored.

If inflation expectations became unanchored, it would make it harder to meet the inflation target, and the changes in interest rates required to re-anchor expectations would likely have large effects on the wider economy.

With regards to exchange rate stability, movements in interest rates have an effect on the exchange rate. Monetary policy has limited ability to affect the real exchange rate beyond the near term, and there can be significant costs in attempting to stabilise the exchange rate.

However, the Reserve Bank has considered the effects of the medium-term exchange rate cycle on the macro-economy and adjusted interest rates as necessary. In addition to its interest rate policy tools, the Reserve Bank also has an exchange rate intervention policy that is used in exceptional circumstances to lean against the peaks and troughs of the exchange rate cycle (see chapter 6).

3.3.4 Strategy under uncertainty

Assessments of the current and future state of the economy are inherently uncertain, but they must be made for the MPC to decide on a policy stance. For example, the Reserve Bank would typically estimate the current values of each key economic variable, including unobservable variables such as the neutral interest rate (see chapter 4). In these estimates, the Reserve Bank makes judgements regarding the risks to the assumed current values and forecasts of key variables in the economy. Consistent application of these judgements over time contributes to a coherent monetary policy strategy.

To communicate the uncertainty within these assessments, the Reserve Bank has historically incorporated a balance of risks into its forecasts and discussed those risks, and possible policy reactions to them, in the MPS. However, when uncertainty is elevated, the MPC has at times chosen to use scenarios to illustrate the range of possible situations and economic outcomes that could occur.

The Reserve Bank has tended to wait for evidence that lower-probability risks are eventuating before reacting to them. However, the MPC may choose to adjust the stance of monetary policy to account for risks under some circumstances – such as when risks are significant, one-sided, or costly to correct for should they emerge. For example, if the risks were viewed as skewed heavily to the downside, the MPC could choose a lower interest rate path than otherwise, resulting in inflation forecasts slightly exceeding the target.

When uncertainty is high and the risks to our objectives more balanced, the MPC has usually tended to have a relatively smooth and slower-moving policy stance. Economic movements implied by the forecasts may not eventuate, and the effects of policy actions are uncertain, so it is usually prudent to move interest rates in small increments.⁴⁶ This means that the MPC can build up a policy stance gradually, responding to unexpected developments in the economy as they occur.⁴⁷ However, the MPC has made larger policy moves when risks to achieving the inflation target were imminent, large, or unbalanced. In these cases, a large response was generally preferred because an initial mild response could require a larger response later, and greater economic harm overall, if the initial response proves insufficient.⁴⁸

3.4 Coherent actions: stance and tactics

When the MPC has a clear vision of its strategy (or guiding policy), implementing that strategy at each policy decision requires judgements about:

1. Stance – how much monetary stimulus the economy requires.
2. Tactics – the current settings of the suite of monetary tools, the published forward path for the OCR, and communication about the stance and risks.

The stance of monetary policy is defined here as the amount of monetary stimulus, or the degree to which monetary policy is supporting or restraining economic activity and inflation. Deciding on the appropriate stance requires an assessment of the current economic conditions, and the risks to that assessment, to determine the trade-offs that exist. Decision makers can then decide what these trade-offs and risks imply for the appropriate stance of monetary policy at each decision, given their overarching strategy.

Monetary policy tactics are the use of monetary policy tools (discussed in chapter 6) to achieve a desired monetary policy stance. The MPC uses its Principles for Monetary Tools to make decisions on which tools to deploy. The tactics of a monetary policy decision are separate from the stance, because there are multiple ways to achieve any given stance. Monetary policy delivers stimulus to the economy by influencing market interest rates (see chapter 5). Therefore, whether the desired monetary policy stance is achieved depends on the reaction of financial markets to the decision, not just the current setting of the OCR or other monetary tools.

In ‘normal’ times, the MPC would likely try to achieve the desired monetary policy stance by deciding on the level of the OCR and providing forward guidance about the expected path of the OCR. The latter is an integral part of monetary policy, as such guidance – when believed – affects expectations of the future and hence private decisions to consume, invest, and employ labour. These longer-run beliefs are integral to successful monetary policy.

Chapter 4: The New Zealand economy

4.1 Introduction

To conduct monetary policy effectively, the Reserve Bank needs a sound understanding of the macroeconomic environment we operate in, and the data we have to help us understand it. This chapter introduces the key features of the New Zealand economy from a monetary policy perspective. As a small open economy, New Zealand has strong links to the global economy so we must also consider the impacts that global economic, political, and financial market developments can have on the New Zealand economy.

This chapter characterises the data we use to inform our economic assessment and forecasts. It also discusses some of the techniques Reserve Bank staff use to understand the economy, particularly parts of the economy that we cannot directly observe or cannot observe in real time.

4.2 What influences inflation?

The inflation objective is the primary operational objective for monetary policy in New Zealand (see chapter 2). Reflecting this, our perspective on New Zealand’s economy and the frameworks we use to understand it are centred around the goals of understanding, assessing, and forecasting inflation.

In simple terms, inflation is determined by the aggregate interactions of demand and supply across the economy, which in turn influence the prices firms decide to set. There are a number of frameworks that can be used to understand inflation. The main framework the Reserve Bank uses is known as a ‘Phillips curve’ relationship. In this framework, the broad range of factors that influence inflation are summarised into two main factors: capacity pressure and inflation expectations.

Capacity pressure is the ‘strain’ the current level of economic activity is putting on resources such as labour and capital. We measure economic activity using gross domestic product (GDP) and its components: consumer spending, investment, government spending, and trade. The ‘strain’ or capacity pressure on the economy is commonly thought of as the output gap – the difference between GDP and the potential output that could be produced if labour and capital were used at their maximum sustainable levels, given current technology and the institutional features of the economy.

When GDP is greater than potential output, we say that there are capacity pressures, and the output gap is positive, leading to inflationary pressures. Increasing capacity pressures are associated with higher inflation because when households and firms compete for scarce goods and services, firms are able to sell their output at a higher price. In addition, when firms compete over inputs (such as labour, capital, and intermediate goods) input costs can rise, which may be passed through into higher consumer prices. When GDP is less than potential output, we say that there is spare capacity, and the output gap is negative which means we can expect less inflation.

Inflation expectations also play an important role in determining inflation. When firms set prices, they either consciously or unconsciously factor in their expectations about future inflation.⁴⁹ Because most firms do not update prices every day they try to set prices such that they will be optimal for the whole period from now until the next price revision, which will depend on the changes in other prices in the economy.⁵⁰

The Phillips curve framework is particularly well-suited to understanding inflation that arises due to conditions in the domestic economy. However, international factors can also influence inflation. Changes in global prices can influence the cost of some goods and services in New Zealand, either directly or by influencing their costs of production. For example, changes in petrol prices are predominantly influenced by global factors, and petrol is a key input to production for many goods and services domestically. The exchange rate is also an important determinant of the prices New Zealand households and firms pay for imported goods and services.

4.3 New Zealand GDP

GDP is a measure of economic activity, equal to the total output produced within an economy over a given period of time. It is an essential piece of information for understanding and predicting inflation and employment. As of late-2023, New Zealand’s annual nominal GDP was NZD 400 billion.⁵¹

Stats NZ produces three official quarterly GDP measures: production GDP, based on industry-by-industry value-add estimates (the value of output minus consumption of intermediate goods and services), expenditure GDP, based on the total spending on final goods and services in the economy, and income GDP, based on the total flow of income in the economy. These 3 measures should be equal in theory, but practical measurement issues tend to produce slightly different numbers. While we favour the production measure for its accuracy and stability at an aggregate level, the expenditure measure breakdown is more useful for macroeconomic modelling. Figure 4.1 shows the breakdown of GDP into its expenditure components.

GDP data are produced quarterly but are only available with a 3 to 4 month lag, making it necessary for the Reserve Bank to ‘nowcast’ both the current quarter and the previous quarter’s GDP. More-timely indicators are available to help inform the Reserve Bank’s nowcasts for aggregate GDP, including ‘hard’ data from Stats NZ that include activity indicators, and ‘soft’ data from surveys. For example, regular business surveys from ANZ and NZIER provide useful information about firms’ own activity levels, as well as information about business confidence, capacity pressures, and employment. Many of the questions are forward-looking, providing some insight into firms’ expectations about the economy in the near future. In addition to these high-level soft-data indicators, the Reserve Bank has access to a large set of industry-specific activity indicators, such as monthly concrete sales, livestock slaughter, dairy production, and electricity production.

The Reserve Bank supplements these data with information gathered directly from businesses through our business visits programme. These visits are often targeted towards understanding specific industries but might also include discussions with broader entities such as local councils and iwi.

The following sections describe the various components of expenditure GDP, their key economic influences, and some of the data that help us understand these variables. Chapter 5 covers in more detail how these components are affected by monetary policy.

4.3.1 Consumption

Consumption is the largest component of GDP, accounting for about 60% of output. Consumption includes all household spending on final goods and services (goods and services that are not inputs into the production of other goods and services).

The Reserve Bank uses a range of data to help us understand consumption. At a high level, monthly data on electronic cards transactions can help nowcast current consumption. To understand consumption more fully and to develop a forecast, we look to the key economic factors influencing consumption, as outlined in table 4.1.

Table 4.1: Factors influencing consumption 

4.3.2 Private investment

Private sector investment includes all fixed capital formation by private businesses (i.e. not the government) and constitutes about 20% of GDP. Private investment encompasses investment in a wide array of capital assets. This includes physical capital, such as residential and non-residential buildings, land improvements, transport equipment, and other plant and machinery. It also includes computer software and other intangible assets, such as those arising from research, development, and mineral exploration.

The factors influencing private investment are broad and varied, leading to occasionally asynchronous dynamics across different industries and capital assets.

Table 4.2: Factors influencing private investment

4.3.3 Government spending

Government spending consists of (a) government consumption on final goods and services, such as spending on ministries, defence, education, and healthcare, and (b) government investment, such as infrastructure construction and maintenance. On average, government spending accounts for about 25 percent of GDP.

When government spending increases, GDP is not expected to increase by the same amount. Government spending can support economic activity by boosting income and employment, which flows through to the rest of the economy. However, increases in government spending may also “crowd out” or reduce other private spending by driving up prices for scarce inputs, such as labour, capital, and materials. In addition, a proportion of government spending is on imports, which do not count towards GDP.⁵⁶

The government may also influence the other components of GDP through changes in taxes and transfer payments (such as Jobseeker Support or Sole Parent Support). A change to taxes or transfer payments would not be seen in the government spending component of GDP. Instead, it would be seen primarily in the consumption and private investment components. For example, increasing current or expected taxation, or decreasing transfer payments, may reduce households’ disposable income, and therefore consumption. A change in taxes may also alter private sector investment by influencing the profitability of investment opportunities.

The Reserve Bank produces forecasts for government spending that directly incorporate forecasts from the New Zealand Treasury, with some statistical transformation and adjustments to account for differences in data specification and major government policy announcements.⁵⁷  One exception is when a major domestic or international event disrupts the New Zealand economy between Treasury forecast rounds. For example, after the Christchurch and Kaikōura earthquakes, the Reserve Bank incorporated judgements about the likely implications into its forecasts based on consultation with relevant government entities.

Interactions with monetary policy

The government’s spending and taxation policies, collectively known as fiscal policy, are naturally less responsive to monetary policy compared to other sectors of the economy. However, fiscal policy can have a significant impact on demand in the economy, and ultimately inflation. The Reserve Bank takes government spending into account when assessing the economic outlook.

For example, when fiscal policy is expansionary and stimulates higher demand, tighter-than- otherwise monetary policy will usually be needed to achieve the Remit objectives. Fiscal policy settings can nevertheless support the objectives of monetary policy. For example, during an economic downturn, increased government spending and looser monetary policy can work simultaneously to stimulate demand.

Similarly, governments must have regard to the interaction between fiscal and monetary policy when formulating their fiscal strategy, as required under the Public Finance Act 1989. Given these interactions, a Treasury observer attends Monetary Policy Committee (MPC) meetings to facilitate co-ordination of monetary and fiscal policy and to support decision making, for example by sharing information on fiscal policy.

4.3.4 Trade

Trade is a significant part of the New Zealand economy. Imports and exports fluctuate over time, but trade has been broadly balanced in recent years, with imports and exports each representing about 30 percent of GDP.

New Zealand’s largest trading partners are China and Australia, with New Zealand typically exporting more than it imports from these countries (Table 4.3).

Table 4.3: Trade with New Zealand’s major trading partners in the year to March 2024 (nominal)

Exports

New Zealand is primarily a soft-commodity exporter, with agriculture, fishing, and forestry comprising around 37% of total exports in the year to December 2023. Dairy is the largest agricultural component, accounting for 18 percent of all exports. New Zealand’s dairy export prices and New Zealand dollar incomes are subject to considerable swings due to variable global demand and production, weather-related impacts on output, and exchange rate volatility.

Tourism and travel services are also major exports, accounting for roughly 12% of total exports as of December 2023, though this proportion was typically higher prior to COVID-19. Because these services are generally priced domestically, New Zealand dollar prices tend to be more stable. However, the volume of tourism and travel services consumed varies with the exchange rate and global economic cycles. Table 4.4 summarises the key factors influencing New Zealand’s exports and the data used to assess these.

Table 4.4: Factors influencing exports

Imports

Some proportion of what is consumed and invested in New Zealand comes from imports. In particular, New Zealand imports a majority of the manufactured durable goods it consumes, such as cars, electronics, and machinery. Petrol and other petroleum products are another key import and, like dairy, can have volatile prices.

Motor fuels are unique in that changes in global prices tend to be passed on to consumers almost immediately. While retailers of other imports tend to pass through price changes gradually, fuel retailers typically adjust prices daily or weekly in line with global oil prices. Table 4.5 summarises the factors influencing New Zealand’s imports and the data used to assess these.

Table 4.5: Factors influencing imports

4.4 Potential output

Potential output is defined as the total output (usually measured in terms of GDP) an economy can produce using labour and capital at their maximum sustainable levels, given existing technology and the institutional features of the economy. It is an important input into the forecasting and modelling of generalised inflationary pressure, as will be discussed further in section 4.6. Conceptually, potential output depends on the size and skills of the labour force, available capital, and the level of technology or productivity.

4.4.1 Labour

Labour is the largest input into production in New Zealand. Stats NZ provides a quarterly estimate of the labour force as part of the Household Labour Force Survey (HLFS). Consistent with international standards, the measured labour force includes all people over the age of 15 currently resident in New Zealand who are either working (employed) or available and actively seeking work (unemployed).

The two factors that contribute to changes in labour availability are changes in the working-age population and changes in the labour force participation rate. Long-term trends, such as natural population growth, changes in average hours worked, or the increasing participation of women in the labour market, are also important, as are shocks such as large swings in net immigration.

4.4.2 Capital

Capital refers to the durable assets that are used in the process of producing goods and services, but which are not fully consumed during the process. Capital includes physical capital such as buildings and machinery, as well as intangible assets such as software (see section 4.3.2). Stats NZ produces an estimate of the stock of capital once per year as part of the annual national accounts, and this is the estimate used for modelling purposes.

Measuring an economy’s capital stock presents considerable challenges. Unlike GDP, which is a flow concept and is contained within a given measurement year, total capital is a stock estimate that accounts for all capital accumulated in years prior to the measurement period. It must also account for the depreciation of that stock over time, which depends on the type of capital and the intensity of usage.

Capital stock can be increased or decreased in response to changes in demand. When firms experience high demand and increased capacity pressure, they are encouraged to invest in more capital. Similarly, when demand is weak, incomes are lower and pressure on resources is low, firms may choose to hold back on investment and allow existing assets to depreciate. Sudden changes in capital stock can also occur, such as infrastructure damage due to natural disasters; however, the rate at which the capital stock adjusts is usually fairly slow.

4.4.3 Productivity

Total factor productivity is the efficiency with which capital and labour inputs are combined to produce goods and services. It is sometimes thought of as technology, but this is a simplification. While technological progress may be the predominant factor influencing productivity growth over time, productivity can also be affected by other factors, such as the matching of the right workers to the right jobs or the efficient allocation of resources to higher-value production.

Productivity is not directly observable and is difficult to define and measure. As a result, productivity estimates are calculated as a residual from other measurements. Once labour and capital inputs and aggregate outputs are measured, productivity can be calculated as output divided by inputs. Stats NZ provides official productivity estimates once a year. Given the need for timely estimates, productivity figures for forecasting purposes are constructed using statistical filters and internally estimated measures of capital and labour inputs.

4.5 New Zealand’s labour market

The labour market is an integral part of the economy and plays a crucial role in shaping inflationary pressures. Interactions between labour supply and labour demand contribute to labour market tightness, which influences wage growth. This section considers the labour market from three perspectives: labour supply, labour demand, and labour market tightness.⁵⁹

4.5.1 Labour supply

Labour supply typically refers to the number of people working or actively looking for work at a given point in time in the economy. It encompasses the supply of people, their willingness to work, and the composition of skills within the labour pool. One key measure of labour supply is the labour force. As noted in section 4.4.1, the labour force is measured as the share of the population over the age of 15 that is either employed or available and actively seeking work. New Zealand’s labour force growth was more than twice the OECD average over the period from 2011 to 2022. This reflects both growth in the working-age population and an increase in the labour force participation rate.

Population increases can result from both natural increase (births minus deaths) and net immigration. Natural increase tends to be relatively stable and predictable, whereas net immigration can lead to more rapid and often unanticipated growth in labour supply, with implications for monetary policy. Similarly, a significant outflow of workers could cause the labour force to contract, although such outflows have been far less common in recent history.⁶⁰

4.7.2 Core inflation

Capacity pressures and inflation expectations are not the only factors influencing inflation. For example, swings in the prices of imported consumer goods can affect inflation independently of changes in capacity pressure. Tax changes, such as changes to Goods and Services Tax, or excise taxes on tobacco, alcohol, or petrol, also have a direct and sometimes large impact on measured inflation. These factors are often transitory in nature and do not necessarily require a monetary policy response.

‘Core inflation’ represents underlying pricing pressures that are likely to persist once temporary shocks have unwound. The Reserve Bank looks at a set of measures that use various techniques to strip out the more volatile component of inflation to provide estimates of core inflation (figure 4.4). There is no single ‘best’ method, with each having its strengths and weaknesses.

Some measures exclude certain more volatile groups, such as food and energy, while others use statistical methods that are less influenced by particularly large price changes for individual items or that measure only the least volatile groups. Other methods have stronger theoretical grounding. These measures help us look past some idiosyncratic or one-off price movements⁶⁶.

Our core model does not differentiate between net savers and net borrowers, or households and businesses that are or are not credit constrained. This means that the cash flow channel is not explicitly captured in our model, but rather is accounted for by a larger intertemporal substitution effect, calibrated to New Zealand data.

5.3.4 The household wealth channel

Changes in interest rates can have a direct effect on household wealth. For New Zealand, housing represents more than two-thirds of households’ total wealth. Higher interest rates reduce demand to purchase houses, reducing overall activity and constraining house price inflation. When house price inflation slows, people may revise lower their perceived wealth and, as a result, decrease their consumption. This is known as a ‘wealth effect.’

The wealth effect is also supported by a ‘collateral effect’ whereby smaller increases in housing equity from capital gains limit how much households can borrow against their homes to finance consumption. Reserve Bank research (Wong, 2017) found that households in New Zealand do indeed vary their consumption in response to changes in housing wealth. However, this work suggests that the propensity of households to consume out of housing wealth has been lower following the GFC than in the period prior to the GFC.

In NZSIM the correlation between changes in house prices and changes in consumer spending is incorporated into the model’s consumption function. As a result, all else equal, higher interest rates slow house price growth, thereby slowing growth in consumption (figure 5.5).

Table 6.1 highlights the impacts of key monetary policy tools on the size of the Reserve Bank’s balance sheet. Importantly, it captures only the direct impacts. The tools can also indirectly impact the balance sheet, such as by influencing the income and expenses of the Reserve Bank or through the measures the Reserve Bank may take to manage the balance sheet impacts.¹⁰⁹

Table 6.1: Direct impacts of monetary policy tools on the size of the Reserve Bank balance sheet

Settlement cash and the money supply

Settlement cash is considered a form of money and is included in ‘base money’, which is one measure of the amount of money in the economy.¹¹¹ As settlement cash has grown, measures of base money have grown. Changes to the level of settlement cash were once a key lever used to set the stance of monetary policy. However, since the introduction of the OCR, the level of settlement cash has been largely irrelevant for the stance of monetary policy in New Zealand.¹¹² The increase in base money has hence been a byproduct of the FLP and LSAP, rather than a key channel through which they impact the economy.

Chapter 7: Principles for good deliberation in the Monetary Policy Committee

7.1 Introduction

Principles are rules or beliefs that govern behaviour. This chapter outlines some underlying principles for deliberation by the MPC. These principles are consistent with the Act, Remit and Charter and inform the formal meeting processes set out in chapter 8.¹¹³

7.2 Principles of genuine MPC deliberation

Personal preferences, cognitive shortcuts and unconscious biases can dictate the way people assess situations, instead of facts and logical analysis.¹¹⁴ In a group of people, dynamics such as freeriding and groupthink (conformity to group norms or decisions) can drive decisions, instead of rigorous debate, questioning and analysis. To overcome these decision-making hurdles, committees often define and agree an explicit set of decision-making principles.

The principles introduced in this chapter focus on how we can support effective deliberation in the MPC. They add clarity to MPC deliberations by facilitating an environment that supports careful diagnosis, evidence sharing and open deliberation so the committee can make unbiased strategic decisions. A summary of the principles is provided in table 7.1.

Table 7.1: Principles of MPC deliberations for monetary policy

7.2.1 Principle 1: Clear objectives

In any committee meeting, there is an optimal time to spend deliberating and making decisions before participants lose focus and energy. Clear objectives harness the collective focus of the group and direct it to the committee’s overall purpose and each meeting’s objectives.