Changing interest rates
When used to provide stimulus, these tools all work to lower interest rates in the economy. Lower interest rates work through a number of channels to encourage more spending and less saving. This in turn boosts inflation and employment levels. Lower interest rates also may depreciate the exchange rate and increase inflationary expectations, also boosting inflation and employment.
The full impact of changes in interest rates on economic activity, employment and inflation typically takes around two years, although the strength and timing of interest rate effects can vary due to factors outside of our control. For example, uncertainty about the future may cause households and businesses to defer their spending and investment plans despite lower interest rates until they have a clearer picture.
While we cannot compel people to spend and invest, our actions to lower interest rates create an environment that supports economic recovery when they will feel more confident to do so.
As the economy improves and inflation and employment pressures build, it becomes necessary to remove stimulus to avoid persistently overshooting our inflation target (of 1% to 3% in the medium term). The Monetary Policy Committee’s preferred primary tool for removing stimulus is raising the OCR.
Supporting the economy and jobs
We expect the road to recovery for the global economy will be slow and bumpy due to COVID-19. The best way we could contribute to economic wellbeing in the initial period following COVID's arrival in New Zealand was to improve all New Zealanders’ job prospects through lower interest rates.
High and persistent unemployment would be the worst outcome as it would erode economic wellbeing and widen income inequalities.
Improving employment prospects will also support financial stability as those with jobs can repay their mortgage, ensuring banks and the financial system remain strong and resilient.
As inflation pressures rise and employment reaches or exceeds its maximum sustainable level, it becomes necessary to remove stimulus to avoid the consequences of persistent high inflation. Persistent high inflation can destabilise the economy because households and businesses find it very difficult to plan and invest when prices are changing so quickly.
Raising prices for houses and other assets
Reducing interest rates and making it cheaper to borrow and spend money can push up the price of assets like houses. It can also increase the share prices of equities held by the three million New Zealanders in their KiwiSaver accounts.
Higher house and share prices make people feel wealthier, encouraging them to spend and invest. While this can help us meet our core mandate – controlling inflation, maximising employment and supporting economic wellbeing – higher house prices affect housing affordability.
Lower interest rates, however, are not the only factors influencing house prices. For example, a historic shortage of houses have also pushed up prices and, in August 2021, we issued a news release stating that house prices were above their sustainable level.