The Impact of the Crisis on Monetary Policy
Speaking notes for a speech to Credit Suisse Asian Investor Conference, Hong Kong
(This presentation focuses on one of the themes from the 11 March Monetary Policy Statement. The Bank's policy outlook remains unchanged.)
- The Reserve Bank of New Zealand expects its monetary policy to have a sharper impact in the post-crisis economic and financial environment.
- Prior to the crisis, New Zealand monetary policy had issues trying to lean against the housing boom. Policy was tightened considerably more in NZ than overseas. Local borrowers "slid out the yield curve" to take advantage of fixed rates which were more influenced by the lower international rates. At the same time, NZ's relatively high short rates put pressure on the NZ dollar through "carry trade" activity.
- RBNZ spent considerable effort in 2005-07 looking for supplementary policy instruments that might reinforce the impact of monetary policy on domestic borrowing and spending. But in the pre-crisis global financial environment of low interest rates and "the search for yield", there were no easy options.
- During the crisis, New Zealand's inflation targeting monetary policy delivered sensible policy responses. The Bank reduced NZ's OCR by 575 basis points from mid 2008 to early 2009, even though headline inflation numbers in 2008 were well above the official 1-3% target band. In effect monetary policy was looking through the short term inflation effects of high oil and other commodity prices. In the Bank's view this flexible medium term approach to inflation targeting remains the best framework for monetary policy in New Zealand.
- In the post-crisis environment, the global financial markets have fundamentally changed, with the effect that monetary policy is likely to have a sharper impact going forward. Four contributing factors are relevant:
- First, a higher cost of funds for the banks is tending to put pressure on lending rates for any given OCR level. This is coming mainly from higher deposit margins as banks compete vigorously to try and increase their customer funding ratios. Pressures to improve the stability of bank funding sources are being seen globally across the banking sector. The pressure is coming from rating agencies, the debt and equity markets, and from bank regulators.
- Second, a more conservative approach by borrowers to debt accumulation and reduced expectations of capital gains through asset price appreciation means that any given nominal level of lending rates will correspond to a higher effective "real" lending interest rate, thus having a greater deterring effect on credit demand.
- Third, New Zealand now has a positive yield curve like other countries. In other words fixed term rates on loans/deposits are considerably higher than rates on short term loans/deposits. This means that borrowers are increasingly moving to floating rates or short term fixed rates which will be quickly affected when monetary policy is tightened. Borrowers will no longer be able to "slide out the yield curve" to avoid the impact of a policy tightening.
- The fourth factor expected to increase the impact of monetary policy going forward is the Reserve Bank's new prudential liquidity policy. An important part of this policy is the Core funding ratio (CFR) which requires banks to obtain a minimum proportion of their funding from stable or ‘core' sources, namely customer deposits or long term debt instruments (over one year to maturity). The Reserve Bank expects that in future boom periods, when global credit conditions are easy and domestic credit is growing rapidly, this Core Funding Ratio will act to push up the cost of funds and moderate the credit cycle, thus tending to reinforce the effect of monetary policy adjustments. By impacting customer lending rates rather than wholesale rates, the CFR should also help to moderate the flow on effect of monetary policy adjustments to the exchange rate.
- The Core funding ratio may thus be a useful "macro-prudential" policy tool, even if it remains at a fixed level. The Reserve Bank is investigating other potential macro-prudential policy tools, in particular some of the proposals coming out of the Basel Committee on Banking Supervision. However, the RBNZ will adopt a very cautious approach to any new macro-prudential instruments. The prime purpose of any such instruments must be financial system stability – the support of monetary policy is a secondary objective. We must also be wary of any measures that add significant costs to banking intermediation, thereby promoting alternative unregulated and less efficient financial channels.