Chapter Three
Banks and Monetary Policy
The level of interest rates has a substantial effect on financial markets, saving and wealth, output and employment, investment, prices, and exchange rates. The Reserve Bank that through monetary policy directly impacts on short-term interest rates. Understanding New Zealand’s monetary policy and its tools helps us make sense of the ability the Reserve Bank has to influence the macroeconomic indicators we discussed in Chapter 2. Reserve Bank announcements and actions are closely watched by financial markets and other sectors in the economy. Monetary policy decisions have important implications for the economy as a whole.
Chapter 3 is split into three major sections. The first section looks briefly at banking and money in New Zealand. The second section examines the Reserve Bank of New Zealand, its role, and its objectives. This leads to the final section, monetary policy in New Zealand. The key role of the Reserve Bank, and the monetary policy tools used by the Reserve Bank will be discussed. In this final section we will look more closely at the Official Cash Rate.
Banking and Money in New Zealand
New Zealand is a country that has one of the fastest uptakes and usage of Electronic Funds Transfer at Point Of Sale (EFTPOS) in retail and banking since its introduction in 1998. New Zealanders use of on-line banking and telephone banking is among the highest internationally. No longer are as many notes and coins found in New Zealanders wallets, rather we are more likely to find EFTPOS and credit cards.
Figures 3.1 and 3.2 show the amount of M1 in the New Zealand economy in the form of notes and coins, and EFTPOS transactions between 1996 and 2002.
Figure 3.1 Notes and coins in New Zealand 1996–2002
Source: The Reserve Bank of New Zealand
Figure 3.2 EFTPOS in New Zealand 1998–2002
Source: The Reserve Bank of New Zealand
The dollar amount of transactions since the inception of EFTPOS has been around 14 per cent more than that of notes and coins. The use of EFTPOS for transactions had an overall growth rate during the period 1998 to 2002 of 20.82 per cent. Certainly New Zealand is a country happy to use EFTPOS as a main source of undertaking monetary transactions in the economy.
There were eighteen registered banks in New Zealand as of May 2003. This number has been fairly stable since the late 1980s when the banking system in New Zealand was deregulated. Changes in banks; however, have taken place as banks merge with other institutions, and new banks are registered. A few examples of the banks that have ceased to be a registered bank due to merger and acquisition processes are: Post Bank (integrated with ANZ Bank),[1] the Rural Bank (integrated with the National Bank),[2] Trust Bank (integrated with Westpac Banking Corporation),[3] and Countrywide Banking (integrated with the National Bank). In terms of asset ranking the five largest banks in New Zealand are: the National Bank, BNZ,[4] WestpacTrust, ANZ, and ASB.[5]
In 2002 Kiwibank came into being, a government-sponsored (and government owned) bank. It operates out of PostShop outlets, its goal to provide low cost and accessible banking. Progressive Coalition MP and leader Jim Anderton is a strong advocate of this bank. In February 2003, the Reserve Bank registered Leviathan Limited as a bank, which operates under the name ‘SuperBank’. It is a joint venture between the Foodstuffs Supermarket group and Australia’s St George Bank.
Since April 1987 any financial institution that met the criteria can apply to the Reserve Bank to become a registered bank. Before this, to become a bank in New Zealand required an Act of Parliament. Deregulation has provided consumers new ways to access finance, and the financial packages and products are far more flexible and competitive. The banking environment is very competitive, banks work hard to attract and keep customers, and technological advances are revolutionising how banking is done, and how consumers access their funds.
Registered banks are one type of bank in New Zealand. The other type is the central bank, known in New Zealand as the Reserve Bank.
The Reserve Bank
In 1933 the Reserve Bank of New Zealand was founded after Sir Otto Niemeyer of the Bank of England was in New Zealand advising the government on foreign exchange and currency. He made three recommendations to the government with respect to the creation of an independent central bank for New Zealand. He advised that the Reserve Bank be responsible for the stability of the New Zealand currency, the sole issuer of currency, and hold the government’s account and the banking system’s reserves. In 1936 the first Labour Government passed legislation to nationalise the Reserve Bank, and give the control of monetary policy to the Minster of Finance. It was not until 1989, some 56 years later, that the independence recommended by Niemeyer was given to the Reserve Bank.
The 1984 election was a key turning point for the Reserve Bank. The fourth Labour Government began a review of monetary policy leading to an about face from that of the first Labour Government on the role and direction of the Reserve Bank and monetary policy in New Zealand. The 1989 Reserve Bank Act was a world-leading piece of legislation. New Zealand was the first country to stipulate that the general level of prices (inflation) be the sole objective of monetary policy. This Act also gave independence to the Governor of the Reserve Bank to undertake the direction of monetary policy, using whatever tools the Governor saw fit. The objectives of monetary policy; however, were still set by the government, outlined in a document signed by both the Governor of the Bank and the Minister of Finance, the Policy Targets Agreement (PTA). This agreement holds the Reserve Bank Governor accountable to the government for the performance of monetary policy in New Zealand.
The Reserve Bank has a board of directors that are appointed by the government; however, the board has no input in (nor responsibility for) the monetary policy used by the Bank. The Reserve Bank Board interviews and recommends to the government the candidate for the position of Governor, the government then signs off on the appointment. The first Governor under the 1989 Act was Dr Donald Brash, who resigned in 2002.[6] The new (as of May 2003) Governor of the Reserve Bank is Dr Alan Bollard, who was the head of Treasury. Changes have been made in the structure of the Reserve Bank with the creation of a Financial Stability Department, and the position of Assistant Governor.
In 2000 the government set up an independent review of monetary policy undertaken by Professor Lars Svensson of Sweden. His report, ‘The Independent Review of the Operation of Monetary Policy’ was released for comment in 2001. One of Svensson’s recommendations was the creation of a formal Monetary Policy Committee responsible for monetary policy decisions. This was not supported by the government, nor the Reserve Bank. The Governor of the Reserve Bank was to remain the person solely responsible for monetary policy; however, more effort was to be made to improve external input into the decision-making process. Another recommendation was the evaluation of the inflation changes to take a more ‘medium term.’ We can see from the 2002 PTA that the inflation target is now considered with respect to the ‘medium term.’
Prior to the 1989 Act, the role of the Reserve Bank was to:
· Be the central bank for New Zealand.
· Ensure that the availability and conditions of credit provided by financial institutions were not inconsistent with the sovereign right of the Crown to control money and credit in the public interest.
· Advise the government on matters relating to monetary policy, banks, credit, and overseas exchange.
· Give effect to monetary policy, within the limit of its powers.
The 1989 Act listed one primary function of the Reserve Bank, which was: ‘To formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices’.
When joining the first coalition government under MMP in 1996 (which consisted of the National and the New Zealand First Parties), New Zealand First made changes to the PTA. The two changes were:
· The inflation target was expanded to 0–3 per cent.
· The wording in the PTA was changed: ‘The Reserve Bank shall formulate and implement monetary policy with the intention of maintaining a stable general level of prices, so that monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the New Zealand economy.’ [new wording in bold]
In 1999 a new PTA was signed and again changes were made to the wording: ‘In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner and shall seek to avoid unnecessary instability in output, interest rates and the exchange rate.’ [new wording in bold]
After the 2002 election and with a new Reserve Bank Governor, a new PTA was signed. There were three changes:
· The Bank was to take a more medium-term approach to achieving price stability (it was said to improve flexibility).
· The inflation target was now 1–3 per cent, raising the lower target (it was now an ‘average over the medium term’ target rather than a point).
· In the primary function of the Bank statement it included the phrase, the Reserve Bank will seek to avoid ‘unnecessary instability in output, interest rates and exchange rate.’
There is acknowledgement in the PTA that unusual events may have a dramatic and short-term impact on inflation in New Zealand that can hide the underlying trend in the price level. Inflation could move outside the agreed on bounds due to effects such as: movements in the prices of goods traded in world markets, changes in indirect taxes (for example GST), changes to government policy that would directly affect prices, and natural disasters affecting a major sector/part of the economy. To this end the Reserve Bank is required to operate in a way that prevents general inflationary pressures, but at the same time to avoid unnecessary instability in output, interest rates, and the exchange rate. The Reserve Bank could override its agreed on inflation bounds in the short-term to account for the unexpected disturbances to the economy; however, it must be done in a transparent way and follow recognised processes to ensure confidence and certainty in the financial markets and the economy.
The Reserve Bank does have other functions in addition to its key goal of achieving price stability. They are as follows:
· To promote a sound and efficient financial system.
· To act as advisor and banker to the government.
· To operate as banker to the registered banks.
· To monitor the domestic foreign exchange market and manage foreign reserves.
· To provide registry services.
· To meet the currency needs of the economy.
· Other activities—for example, public information, overseas representation, and liaison.
New Zealand has a unique way of handling prudential supervision (that is maintaining a sound financial system), as neither the Reserve Bank nor the government guarantees bank deposits. Instead, there is an explicit legal process that makes bank directors personally responsible for how risk is managed by their bank. The Reserve Bank also requires banks to keep their capital adequacy ratio above eight per cent. On 25 November 2002, Reserve Bank Governor Alan Bollard spoke to the Rotary Club[7] of Wellington, and during this speech he said that the ‘overall purpose of the Bank, as [he] sees it, is to maintain the stability and efficiency of the New Zealand financial system.’ Through the monitoring of registered banks, ensuring they comply with the financial disclosure regimes, the required capital adequacy ratios and the loans limits they can make to related parties, all work towards creating a sound financial system that both domestic and international users have confidence in.
The New Zealand government floated the dollar in 1985, and since then the Reserve Bank has not used its foreign currency reserves to influence the New Zealand exchange rate. The Reserve Bank maintains foreign reserves for three key reasons. First, to ensure an option if New Zealand faces a serious liquidity problem in its foreign exchange market; second, so people who look to invest in New Zealand can see the foreign reserves as an indication of New Zealand’s financial health. Third, it enables the Reserve Bank to operate in the foreign exchange market, and get first-hand experience of the market and its fluctuations, which is useful when conducting monetary policy in New Zealand.
Every six months the Reserve Bank is required by law to present a policy statement that discusses its past performance and provides information about future monetary policy. The Reserve Bank; however, produces its ‘Monetary Policy Statement’ every quarter (every three months) rather than every six months. This policy statement is to ensure good information is available to the government, the markets, and the economy about monetary conditions and policy performance. Future economic conditions, the estimated path of economic indictors, and the Reserve Bank’s response to them is outlined. Transparency and communication are key in New Zealand’s monetary policy environment.
Monetary Policy
Pre-Official Cash Rate
From 1973 until February 1985, the supply of money was controlled by a reserve asset ratio system (RAR). Banks in New Zealand were required to keep a percentage of the deposits they received on reserve. When the RAR was removed as the major monetary policy instrument in 1985 it stood at 28.5 per cent.