Monetary Policy Tools and the RBNZ Balance Sheet

Key messages

• LSAP and FLP were launched in the face of an unprecedented global economic shock caused by COVID-19. Both programmes were implemented to reduce the risk of a deep recession in which inflation, economic activity and employment could become persistently depressed. 
• LSAP and FLP were necessary because the OCR was close to its ‘effective lower bound’ and could not go negative because commercial banks were unable to operationally manage negative interest rates at the time. 
• LSAP corrected significant dysfunction in the NZD bond market and lowered long-term bond yields, which passed through to interest rates more broadly within the economy. FLP helped lower retail interest rates by providing banks with certainty of funding at a relatively low rate that was able to be passed on to borrowers. 
• The return of liquidity and stability in the government bond market promoted broader financial stability in markets, enabling ‘business as usual’ activity for government and firm capital raising at reduced interest rates. Lower interest rates also contributed to higher aggregate spending, investment, employment, profits, and tax revenue in the economy. Unemployment, business failures, welfare expenditure and long-term economic scarring were all lower than otherwise. 
• By using LSAP and FLP, the RBNZ was able to provide additional monetary support to New Zealanders, even though the OCR remained unchanged at 0.25%. All this was achieved in the face of extreme economic uncertainty associated with an unprecedented global pandemic. 
• As economic conditions improved, asset purchases under LSAP were wound down and halted by July 2021. A gradual reduction in bond holdings was announced in February 2022, before other central banks that had deployed similar tools. The initial allocation of the FLP closed in June 2022, with an additional allocation available until December 2022, as agreed on establishment.
• The monetary stimulus currently being provided by the LSAP and FLP is small and will continue to wane through time. This modest impact can effectively be offset via the OCR. While LSAP and FLP did provide some support to bank funding and liquidity positions, there is little evidence that higher settlement cash balances resulting from these programmes have directly impacted on bank lending.
• The success of LSAP and FLP should be judged on the basis of their risk adjusted net benefits. The positive impacts of these monetary policy tools – such as supporting economic activity through the pandemic and normalising financial markets – also need to be taken into account alongside the costs of the programme.
• The OCR remains the most effective tool for managing the overall level of monetary stimulus through economic cycles. The banking system is now in a position to accommodate negative interest rates, and this will form part of the monetary policy toolkit in future.

The purpose and function of the RBNZ

The Reserve Bank of New Zealand – Te Pūtea Matua (“the RBNZ”) is mandated to achieve monetary policy and financial stability goals, amongst others. These goals are interrelated, in that low and stable inflation is an important part of financial stability, and both are necessary means of achieving the RBNZ’s ultimate purpose of enhancing economic wellbeing and prosperity for all New Zealanders. 

As New Zealand’s central bank, the RBNZ provides transactional banking services for banks operating in New Zealand. We ‘bank the banks’ and the Government by providing them with transaction accounts with us, so they can make payments between themselves, including clearing international foreign exchange transactions. 

Sitting at the heart of New Zealand’s financial system, the RBNZ has a big influence on financial conditions within our economy. RBNZ actions aimed at influencing financial conditions are interrelated through the use of our balance sheet (assets and liabilities), operational tools (e.g. the Official Cash Rate), and other policy instruments (e.g. prudential rules that govern how much risk regulated entities can take).

The RBNZ’s balance sheet is a subset of the consolidated Government (Crown) balance sheet. However, there are legislatively defined rules of engagement between the RBNZ and the Crown to ensure that the RBNZ has sufficient operational independence and the financial capacity to achieve our goals, while maintaining transparency of, and accountability for, our decisions.

Public understanding of our purpose, activities, and tools is critical in ensuring our credibility and, hence, effectiveness in achieving our goals. 

The RBNZ’s monetary policy tools

To achieve our monetary policy goals – maintaining low and stable consumer price inflation while contributing to maximum sustainable employment – we set and influence the level of NZ dollar interest rates in an effort to balance aggregate spending and investment activity (demand) with the supply of goods and services in the economy. 

By setting interest rates to keep aggregate demand in balance with the supply capacity of the economy, the RBNZ acts to keep consumer price inflation low and stable and to support maximum sustainable employment. 

The RBNZ has a range of monetary policy tools at its disposal to influence interest rates – and hence demand – in the economy. The RBNZ also has tools to help promote financial stability.

The most significant tools used by the RBNZ to achieve our monetary policy goals and promote financial stability are outlined in Table 1. The RBNZ’s policy tool kit has evolved and expanded over time, in line with financial innovation and changes in the economic context in which we operate. 

The choice of which tool to use at any given time depends on the economic context and the principles being adhered to by RBNZ policymakers. The principles used to select the most appropriate monetary policy tool to use at any given time are outlined in Table 2. The economic context determining the choice and calibration of a monetary policy tool is regularly outlined in Monetary Policy Statements and associated communications. We operate transparently to ensure that the economic context and principles driving the choice of tool are publicly understood.

The Official Cash Rate (OCR) is the main tool used by the RBNZ to influence interest rates. This is the overnight interest rate (price) that the RBNZ pays banks on the cash balance in their transaction accounts at RBNZ.

As well as controlling the OCR, the RBNZ can also influence other short-term interest rates in the economy by changing the level of cash (or liquidity) available in the financial system. This is done by buying or selling other financial assets, which effectively amounts to swapping RBNZ cash for somebody else’s asset. These tools are called ‘quantitative tools’ in that they influence the quantity of cash in the system. However, as with the OCR, the aim of using these tools is still to influence the level of interest rates (price) in the economy. 

Additional tools needed in response to COVID-19

Over recent years, as New Zealand’s economic context has evolved, the RBNZ’s monetary policy tool kit has broadened. 

For a decade or so prior to 2020, consumer price inflation was at very low levels globally, and often below the mandated targets of many central banks. With very low inflation, nominal interest rates – including central banks’ official rates – reached record low levels, and even went negative in some countries (Figure 1). In New Zealand during this period, CPI inflation was low and dipped below the RBNZ’s inflation target band, even though the OCR was cut to low levels.

Figure 1: Short-term interest rates, selected countries

In this environment, the RBNZ started to investigate the feasibility of pushing the OCR below zero, should additional monetary policy stimulus be required. However, exploratory work done in 2019 found that many of New Zealand’s commercial banks were not operationally ready to manage negative interest rates, should they be required.

This raised serious concerns about any unintended impacts of a negative OCR on the efficient functioning of the New Zealand financial system. With the OCR near its effective lower bound (near zero), the RBNZ began developing additional monetary policy tools. The RBNZ also instructed commercial banks to prepare themselves for a negative OCR, should that be required in future. 

With further cuts to the OCR constrained, ‘quantitative’ tools – such as the ‘Large Scale Asset Purchase Programme’ – became increasingly necessary as options for implementing monetary policy.

By early 2020, with the global onset of the COVID-19 pandemic, the need to deploy additional monetary policy tools became increasingly apparent. With the OCR at its practical limit, additional ways of providing monetary stimulus were required if the RBNZ was to achieve its monetary policy and financial stability goals. 

With COVID-19 spreading across the world, fatalities increasing exponentially, and uncertainty about vaccine development, the global and domestic economic outlook became extremely uncertain and concerning, with some very bleak downside scenarios in view. Under advice from public health officials, governments took unprecedented steps to try and deal with the health shock of a global pandemic. Large parts of economies were literally shut down at short notice and with no due date for reopening.

International financial institutions and virtually all other forecasters were predicting extremely serious and persistent negative consequences for the global economy. Deep recessions, double digit unemployment rates, and entrenched deflation were commonly seen as plausible scenarios in the absence of significant monetary and fiscal policy support.

As well as extremely worrying economic forecasts, financial markets – including markets for low risk government debt – were becoming increasingly dysfunctional. This raised the very real risk of broader financial instability in the absence of liquidity support from the RBNZ. 

Large Scale Asset Purchases (LSAP)

The LSAP was designed and implemented to help the RBNZ achieve its monetary policy goals and to provide liquidity and confidence to financial markets. In turn, this would limit financial instability and ensure the efficient and effective transmission of monetary policy. 

In implementing LSAP, the RBNZ purchased (fixed-rate) NZ Government bonds in the secondary market (i.e., not directly from New Zealand Debt Management) to lower wholesale interest rates in the economy. 

The yield (i.e., the return to investors) on government bonds is considered to be the lowest risk benchmark interest rate and has a big influence on other (longer-term) interest rates in the economy. The RBNZ’s willingness to purchase government bonds under LSAP pushed their price up and reduced their yield, thereby lowering benchmark interest rates.

This lowered and stabilised longer-term interest rates in New Zealand and ensured that the Government and corporate borrowers had ready access to capital over an incredibly difficult period. 

Funding for lending programme (FLP)

In addition to LSAP, the RBNZ launched FLP in December 2020 as a means of providing additional monetary policy stimulus to the economy. The FLP was designed to give commercial banks access to some 3-year funding at the OCR over a two-year window. The term and availability window were critical design features aimed at giving commercial banks confidence to incorporate FLP into their medium-term funding plans. 

With the cost of FLP funding for commercial banks set at the OCR, funding costs move in line with the stance of monetary policy. For example, a monetary policy tightening, implemented through an increase in the OCR, increases the cost of FLP funding for commercial banks. However, FLP is still a relatively cheap source of funding, especially compared with the cost of wholesale funding. 

FLP was designed to provide certainty of funding for commercial banks and lower funding costs, which would flow through to lower household and business borrowing rates and support credit availability within the economy. 

The FLP’s primary influence on bank funding costs is not directly through the funding it displaces. This is because, at a maximum of 6% of total bank funding, the FLP does not have a huge influence on the weighted average cost of bank funding per se. Rather, the FLP affects the marginal cost of other sources of funding by reducing competition for those funding sources (e.g., retail deposits). In doing this the benefit of the programme is extended to all Financial Institutions, not just those that secure funding through FLP.

The risk-adjusted net benefits of Monetary Policy actions

Over the pandemic, all the monetary policy tools used by the RBNZ – i.e., the OCR, LSAP, and FLP – worked to lower interest rates. Despite the use of additional monetary policy tools, the goal of monetary policy did not change. Likewise, the transmission mechanism – the way in which lower interest rates impact on economic activity and inflation – is also more or less the same irrespective of the tool used.

The overall benefit to New Zealanders from the use of a monetary policy tool should be considered on the basis of its ‘net expected risk adjusted return’. That is, the return from deploying a monetary policy tool reflects the economic gains that result (relative to what would have happened otherwise) net of any implementation costs and adjusted for the risks associated with using the tool (Table 3).

The economic benefits

In this framework, the economic outcomes arising from the use of the tool, relative to what would have happened in the absence of monetary policy support, are a key driver of net benefit. The benefits of economic and financial stability – including low and stable consumer price inflation – are universally accepted. The critical role of central banks in achieving these outcomes is also well understood and accepted internationally.

In practice, unpicking the economic impacts of specific changes in monetary policy is challenging, especially over recent years with a range of shocks and policy interventions washing through the economy.

RBNZ modelling shows that while OCR cuts were clearly critical, LSAP and (less so) FLP were also key in lowering interest rates and loosening overall monetary conditions. By using LSAP and FLP, the RBNZ was able to provide additional monetary support and financial market stability to New Zealanders, even when the OCR couldn’t be lowered due to operational constraints in the financial sector.

While it is extremely difficult to isolate the individual economic impacts of LSAP and FLP, lower interest rates brought about by accommodative monetary policy were fundamental in supporting economic activity over the pandemic.

RBNZ actions led to higher than otherwise aggregate spending, investment, employment, profits, and tax revenue in the economy. Lower interest rates along the yield curve also put downward pressure on the exchange rate, contributing to improved net export revenues. Unemployment, business failures, welfare expenditure and long-term economic scarring were all lower than they otherwise would have been. 

In addition, the return of liquidity and stability in the government bond market promoted broader financial stability, enabling ‘business as usual’ activity for government and firm capital raising and financial intermediation. All this was achieved despite the continued extreme economic uncertainty associated with an unprecedented global pandemic.

Overall, New Zealand’s economic performance over the last two and a half years has far exceeded expectations at the beginning of the pandemic. For example, real GDP in 2020/21 was over 10% higher than forecast in Budget 2020 (about $27 billion in 2009/10 dollars). Unemployment in 2020/21 was almost four percentage points less than forecast in Budget 2020 (about 100 000 people) while tax revenues were about $19 billion above forecast. 

This better-than-forecast performance reflects many factors, including highly expansionary fiscal policy and the successful elimination of COVID-19 (notwithstanding intermittent lockdowns). Clearly, monetary policy and financial stability also played an essential role in offsetting the economic fallout from the pandemic and associated lockdowns. 

Currently, consumer price inflation is above the RBNZ’s target range. Estimates of core inflation,  which measure the persistent component of inflation, range between four and six percent per annum, well outside of the one to three percent inflation target range.

With the benefit of hindsight, this indicates that monetary policy was too stimulatory at some stage during the tumultuous economic period of the pandemic. In response, the OCR is now above its neutral rate until domestic demand better matches the supply capacity of the New Zealand economy.

This pattern in monetary policy settings is a global phenomenon and has occurred in many other countries around the world since the onset of the pandemic. There will be important lessons in this for the RBNZ – captured in our forthcoming review – and for domestic and international policymakers more generally.

Importantly, during the period of extreme economic uncertainty in 2020, the Monetary Policy Committee – who set monetary policy at the RBNZ – clearly communicated that there could be some ‘policy regret’ in future, given the circumstances. Managing future high inflation down, rather than dealing with deflation and economic depression, was considered to be the ‘least bad’ regret, if one was forced to choose.

We are now well advanced in tightening monetary policy to manage inflation down into the RBNZ’s target range, having avoided economic depression, deflation, and unnecessary high unemployment.

The balance sheet and cost impacts

While the monetary policy tools used in response to the pandemic all influence economic outcomes in more or less the same way – via lower interest rates – the financial accounting implications and impacts on the RBNZ and Crown balance sheets and Crown income statement differ (Table 4). 

OCR

An OCR cut lowers short-term interest rates in the economy, as banks access cash at a lower borrowing cost from the RBNZ and on-lend to their customers at lower interest rates. While the impacts on the RBNZ and Consolidated Crown Balance Sheet are negligible, a lower OCR improves Government net incomes by reducing Government borrowing costs.

LSAP

A reduction in longer-term interest rates via LSAP purchases also lowers borrowing costs across the economy, including for Government. However, because execution is via an asset swap – RBNZ cash for a bond in the secondary market – LSAP does impact on the RBNZ and Consolidated Crown balance sheets. This impact is primarily within the Government’s accounts – i.e., between the RBNZ’s balance sheet and the consolidated Government accounts – and LSAP has minimal impact on the overall size of the Crown’s balance sheet. 

LSAP does influence the composition of the balance sheet, by increasing the level of settlement cash that commercial banks hold at the RBNZ. While higher settlement cash has provided some support to bank funding and liquidity positions, there is little evidence that this has increased bank lending. Instead, the volume of bank lending reflects a multitude of other factors, including customer demands for loans, banks’ perceptions and appetite for risk, and the prudential requirements on banks’ capital, liquidity and funding. 

The direct financial costs of LSAP – made up of funding cost and the market value of the bonds – reflect changes in the OCR (the RBNZ’s funding cost), which depends on economic conditions. For example, if the New Zealand economy had entered a deep recession due to the pandemic, interest rates would have been lower for longer and LSAP would have likely reduced Crown financing costs. 

As it has turned out, the economy recovered more quickly than expected and interest rates have increased. As a result, the LSAP has now led to an overall increase in the cost of Government borrowing, after an initial period of lower costs. The costs of LSAP are beginning to be realised as the RBNZ has begun selling bonds back to Treasury from July 2022 at a rate of $5 billion per year in a higher interest rate environment. 

In effect, the LSAP increased Government’s exposure to shorter-term interest rates. Because short rates are more volatile than longer-term interest rates, this has increased volatility in Government funding costs. The best estimate of the net cost of LSAP is measured by the value of the Crown’s indemnity – unrealised losses based on current market valuation, reflecting a higher OCR – and losses realised by RBNZ upon the sale of the Bonds.  

FLP

The impact of FLP on the Consolidated Crown Balance Sheet is negligible, given that it increases both assets and liabilities. FLP does result in higher settlement cash balances, but, as with LSAP, this is unlikely to have led to a significant increase in commercial bank lending. 

The costs associated with FLP are also minimal given that the RBNZ offered FLP loans at a floating rate, tied to the OCR. This design means the overall interest rate risk from the FLP is minimal, irrespective of what happens to interest rates in the economy. 

Adjusting for risk

The net benefits of the RBNZ deploying its monetary policy tools also need to account for the risks associated with the policy action relative to the case of no action. While difficult to quantify, Table 5 offers a brief assessment of the risks associated with the deployment of the LSAP and FLP.  

Conclusion

The New Zealand economy has outperformed forecasts made at the beginning of the COVID-19 pandemic. The deployment of RBNZ’s monetary policy tools clearly contributed to this out performance and the avoidance of the negative outcomes that would have otherwise occurred.

Accurately assessing the net expected risk adjusted return of different monetary policy tools is far from straightforward. Because monetary policy influences the macro economy, any serious evaluation of policy effectiveness needs to consider a range of macro outcomes, including any impacts on government funding costs. 

The RBNZ is current undertaking a detailed assessment of its monetary policy actions over the past five years, as required by the Reserve Bank Act (2021). To ensure this assessment is fair and transparent, it will be externally peer reviewed by two international experts on monetary policy. The RBNZ aims to learn as much as possible from this review, which will provide a balanced assessment of the net benefits of RBNZ’s monetary policy actions over the past five years. The RBNZ will publish this work towards the end of 2022.

Additional Resources

Reserve Bank of New Zealand

• Bulletin: RAMPed up: the RBNZ’s Additional Monetary Policy Toolkit
• Speech: Covid-19 and the Reserve Bank’s Balance Sheet
• Website: Using our balance sheet to support monetary and financial stability
  • More information on Large Scale Asset Purchases
  • More information on Expanded Large Scale Asset Purchases
  • More information on Indemnity arrangements with the Minister of Finance
  • More information on halting Large Scale Asset Purchases
  • More information on the gradual reduction of the LSAP portfolio
  • More information on the Funding for Lending Programme
• Domestic Markets Announcement: RBNZ details planned sales of NZGBs

Other sources

• BoE: Perspective on Functioning and Effectiveness of QE
• Brookings: What if the Federal Reserve books losses because of its quantitative easing?