Central Bank Inflation Targetting

The Reserve Bank of New Zealand has published a Bulletin article on “An international comparison of inflation-targeting frameworks“. The article compares the inflation-targeting frameworks of 10 advanced economy central banks.

The Reserve Bank of New Zealand (‘RBNZ’) began targeting inflation as a mechanism to ensure price stability in 1988. The RBNZ’s inflation target framework was then formalised with the Reserve Bank of New Zealand Act (1989) and when the first Policy Targets Agreement (‘PTA’) was set in 1990. The Bank of Canada was the second central bank to target inflation, in order to achieve price stability, in 1991. Since then inflation targeting has become internationally regarded as a conventional monetary policy framework. Inflation-targeting frameworks have continued to evolve based on individual country experiences; consequently it is useful to periodically compare the formal and informal inflation-targeting frameworks across advanced economies and understand the key similarities and differences. A previous article by Wood and Reddell (2014) compared the goals for monetary policy across inflation-targeting countries by focusing on primary legislation. This article expands on that analysis by comparing the inflation-targeting frameworks, including informal frameworks, with actual practices.

This article compares the frameworks and practices of 10 advanced economies that employ either full or partial inflation targeting.  This includes six ‘fully fledged’ inflation-targeting central banks: Reserve Bank of New Zealand, the Bank of England (‘BoE’), Norges Bank, the Bank of Canada (‘BoC’), the Reserve Bank of Australia (‘RBA’), and Sveriges Riksbank (‘Riksbank’). These banks explicitly target inflation over a specified time frame in order to achieve price stability, have monetary policy independence, regularly announce monetary policy decisions, and are accountable for policy decisions. Several large central banks also use elements of inflation targeting without either explicitly announcing an inflation target, or they have other objectives alongside low and stable inflation. These are the European Central Bank (‘ECB’), the Swiss National Bank (‘SNB’), the United States Federal Reserve (‘Fed’), and the Bank of Japan (‘BoJ’). Given their importance to international monetary policy, we also assess their frameworks and practices.

The comparison covers five components of an inflation-targeting framework: inflation target definition, communication of monetary policy, secondary considerations5, assessment of the inflation-targeting performance, and framework reviews and revisions. The comparison reveals four key findings.

  1. Despite large differences across inflation-targeting frameworks, the central banks operate and communicate monetary policy similarly.
  2. The central banks pursue forward-looking inflation targets and produce reports that support ex ante and ex post performance
  3. The central banks take account of secondary considerations when setting monetary policy, but not all inflation-targeting frameworks detail how central banks should make these secondary considerations, particularly with regard to financial stability.
  4. Several countries have published reviews of and made revisions to their inflation-targeting frameworks. However, the revisions to the frameworks are not always based on recommendations from published reviews.

The most striking observation from the paper however is the fact that most of the central banks do not expect inflation to return to target any time soon.

This would imply lower interest rates for longer, despite asset price bubbles. This begs the question, is inflation targetting really good and effective policy?

New Factors Play Into Central Bank Forecasting

An external central banking expert has commended the New Zealand Reserve Bank’s forecasting and monetary policy decision -making processes. However, two areas are recommended for further analysis. The first is what the changing labour market under heavy immigration means for non-tradable inflation.  The second is what the ‘new normal’ for monetary policy after years of very low interest rates means for future monetary policy.  The impact of interest rate increases on the financial industry and on the real economy may be quite different than in the past.

As part of good practice peer review, the Bank regularly commissions reviews by external experts of its forecasting and monetary policy decision-making processes.  It has modified its processes over the years in light of their findings.

Dr Philip Turner, former Deputy Head of the Monetary and Economic Department and a member of Senior Management of the Bank for International Settlements (BIS), was requested to attend the February 2017 forecasting round, report on his assessment of the process, and make recommendations where relevant.

Dr Turner comments that, in seeking to “avoid unnecessary instability in output, interest rates and the exchange rate”, the Bank’s mandate is realistic about what monetary policy can achieve.

“This mandate would not have been fulfilled in recent years, given the large shocks to international prices, by trying to keep the year-on-year inflation rate in New Zealand at close to 2 percent.  To have achieved this, interest rates would have had to move by more than they have in recent years, and this would have created the unnecessary instability in output and the exchange rate that the RBNZ is enjoined to avoid.”

Dr Turner says it was clear that the Bank’s Monetary Policy Committee, which advises the Governing Committee on the monetary policy decision, has in its sights key questions about what might be called the ‘new normal’ for monetary policy.

These include the lower natural or neutral rate of interest; the increased responsiveness of aggregate demand to any change in interest rates; and how macro-prudential policies will affect monetary policy.

He says that the Bank’s open working-level culture of challenging views or arguments in a constructive and professional way enables the Bank to avoid ‘policy blind spots’.

“The whole forecast round has been engineered to bring to bear a full range of economic analyses and to ensure an open and comprehensive debate.”

Dr Turner recommended further work on two topics.

“Both are on the radar screens of RBNZ economists. The first is what the changing labour market under heavy immigration means for non-tradable inflation.  The second is what the ‘new normal’ for monetary policy after years of very low interest rates means for future monetary policy.  The impact of interest rate increases on the financial industry and on the real economy may be quite different than in the past.”

Dr Turner concludes: “Results over the past few years speak for themselves.  The RBNZ has helped steer its economy through several large external shocks.  Because it has done so without becoming trapped at a zero policy rate and without multiplying the size of its balance sheet by buying domestic assets, it has retained more room to pursue, if needed, a more expansionary monetary policy than is available at present to many central banks of other advanced economies.”

RBNZ Considers The Australian Connection

One really interesting observation from the recent IMF review of New Zealand’s financial system was the structural inter-dependency with financial services in Australia, not least because much of the banking footprint in NZ stems from Australian parent companies. Now the Reserve Bank in New Zealand has published its response. The Reserve Bank will consider how it can more actively cooperate and coordinate with the Australian Prudential Regulation Authority (APRA) in the on-going regulation and supervision of the large Australian-owned banks.

The IMF recommends a number of steps to strengthen institutional arrangements, define responsibilities, and to clarify the objectives necessary to support the operational independence of New Zealand’s financial regulators. These recommendations cover prudential regulation and supervision, crisis management, and macro-prudential policy.

The IMF notes that the Reserve Bank, as a financial regulator, must have a suitable distance between itself and the executive branch of government. Independence is a necessary pre-condition for optimal policy and supervisory outcomes, albeit this needs to be supported by a robust framework that holds the Reserve Bank accountable to both government and the public.

Cooperation with Australian authorities

The IMF recommends strengthening collaboration and cooperation with the Australian authorities in order to recognise the important interdependencies between the two financial systems. The IMF recognise that there are already well-developed working relationships between the New Zealand authorities and their Australian counterparts.

This is reflected in on-going supervisory contact between the Reserve Bank and its counterpart in Australia, as well as through forums such as the Trans-Tasman Banking Council (TTBC) which is a body comprising various New Zealand and Australian agencies.

Reserve Bank response

The Reserve Bank has already begun the process of reviewing all the relevant findings and recommendations. The initial focus is on the extent to which greater alignment with international orthodoxy – as envisaged in most of the recommendations – might further contribute to the Reserve Bank’s statutory objectives tied to the promotion of a sound and efficient financial system.

The Reserve Bank continues to believe that its three-pillar framework, and an emphasis on self- and market discipline, has served New Zealand well. That said, there are a number of recommendations that, if adopted, may support financial system outcomes and the statutory purpose of the Reserve Bank.

In this regard the Reserve Bank will consider how it can more actively cooperate and coordinate with the Australian Prudential Regulation Authority (APRA) in the on-going regulation and supervision of the large Australian-owned banks.

The Reserve Bank will work with the Treasury to consider those recommendations tied to the ‘institutional boundary’ question in order to preserve and enhance a suitable degree of operational autonomy.

More generally, the Reserve Bank will be closely examining those recommendations that taken together may enhance the three-pillar approach to regulation and supervision. Elements of this model could include more independent verification or validation of information provided by regulated institutions, and a greater use of thematic reviews.

Other elements of this enhanced BAU model could include more clearly articulated (and enforceable) policy requirements, a re-emphasis on conservative and simple regulatory settings, and a more systematic and consistent approach to disclosure in the insurance sector. The review of the bank attestation regime currently in progress is likely to provide some insights into the value of the attestation process, how it could be enhanced and possibly how it could be applied to other sectors the Reserve Bank supervises.

The Reserve Bank will provide quarterly reporting, along with other agencies, to the Minister on progress in implementing FSAP findings and recommendations via CoFR.

NZ Reserve Bank outlines stance on cyber issues

The New Zealand Reserve Bank had thought about whether to introduce more prescriptive requirements in managing cyber security risks but decided not to at this stage.

A recent paper by the Committee on the Global Financial System (CGFS) and Financial Stability Board highlights that financial risk in fintech platforms may be higher than at banks due to greater exposure to digital processes. Some new fintech platforms rely on investor confidence for new business, so are particularly vulnerable to a significant operational risk event, including cyber-attack that may result in a loss of investor confidence.

Firms in the finance sector, regulators, and other authorities all have a part to play in managing cyber security risks while still benefiting from the opportunities of new financial technology.

“The dynamic cyber environment means organisations have to be nimble in their approach to cyber security – focused on outcomes, rather than prescriptive compliance exercises,” Reserve Bank Head of Prudential Supervision, Toby Fiennes, said in a speech delivered today to the Future of Financial Services conference, in Auckland.

He said that cyber-attack poses a significant threat to the global financial system, as shown by the ‘WannaCry’ ransom-ware attack that affected more than 200,000 systems around the world and the more recent ‘Notpetya’ attack.

“The nature and incidence of cyber risk is unique, meaning that typical approaches to risk management and disaster recovery planning may not be appropriate. While cyber vulnerabilities can be mitigated, the potential sources of cyber threats and the attack footprint are just too broad, so they can never be eliminated,” Mr Fiennes said.

“We doubt that prescriptive regulations would appreciably improve the outcome, when the technology and threat landscape are both changing so rapidly. We will, however, review this policy stance from time-to-time to ensure that it remains appropriate,” Mr Fiennes said.

“The Reserve Bank is closely watching the emerging wave of ‘digital disruption’ affecting the financial sector as firms react to customer demand for a more online experience. In the short term, digital disruption may result in new risks and increased instability in the financial system but in the long term, digital disruption of the banking sector may improve the efficiency of the financial system. The long-term impact on financial system soundness is less clear.

“We’re working with other agencies, such as the FMA and Ministry of Business, Innovation and Employment, to ensure that New Zealand presents an environment where digital financial innovation can flourish, provided it is done safely. In our view, New Zealand’s financial market regulatory settings support innovation and industry-based solutions and we see no need to actively steer potential solutions from industry by providing a concessionary environment for new entrants.

“As the prudential regulator, we’re looking at whether financial institutions appear to be taking cyber risks sufficiently seriously. We look to self-discipline and market discipline to provide the defences, agility and crisis preparedness that are required,” Mr Fiennes said.

 

NZ Reserve Bank consults on what should qualify as bank capital

The NZ Reserve Bank has started a public consultation about what type of financial instruments should qualify as bank capital. They offer a range of potential options from simple to more complex and highlight the trans-Tasman context.

Capital regulations address not only the minimum amount of capital that banks must hold, but also the type of financial instruments that qualify as capital. The consultation that starts today is about the nature of financial instruments that are suitable, rather than the amount of capital.

Important considerations for regulations about bank capital include: the Reserve Bank’s regulatory approach; the resolution regime in the event of a bank facing difficulties; international standards issued by the Basel Committee on Banking Supervision; the Reserve Bank’s experience with the current capital regime; and the fact that dominant participants in the New Zealand banking market are subsidiaries of overseas banks. The consultation paper discusses these issues and outlines five options for reforming existing regulations.

The Bank’s proposed reforms to capital regulations aim to reduce the complexity of the regulatory regime; provide greater certainty about the quality of capital that banks hold; and reduce the scope for regulatory arbitrage.

The options consist of “bundles” of reform measures made across 6 dimensions. The measures are combined in such a way that the options provide a gradual shift from the status quo towards:

  • Reduced complexity for the capital regime;
  • Greater certainty as to the loss-absorbing quality of regulatory capital;
  • A more level playing field; and,
  • A reduced risk of regulatory arbitrage.

The consultation closes at 5pm on Friday 8 September.

They also mention the “trans-Tasman context”

An important context for New Zealand’s bank capital regulations is the dominance of four large banks (the “big four”). Each of the big four is a locally incorporated subsidiary of an Australian-incorporated banking parent. Between them the “big four” account for almost 90% of aggregate bank assets in New Zealand.

The big four banks are subject to Australian and New Zealand bank capital regulations – capital issued by the big four potentially qualifies as capital both for the New Zealand bank and for the Australian parent. This is important for a couple of reasons:

  • The Australian regulator’s requirements of the Australian parents can flow down into terms and conditions in the instruments issued by New Zealand banks and these may be problematic in the New Zealand context. An example would be the requirement that, in order to be recognised as capital for the Australian parent, contingent debt issued by the New Zealand subsidiary must, if it offers conversion, convert into listed ordinary shares (the New Zealand subsidiaries do not list their ordinary shares).
  • Banks prefer requirements to be aligned, as this reduces their costs of compliance with both regimes.

RBNZ Official Cash Rate unchanged at 1.75 percent

The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent.

Global economic growth has increased and become more broad-based.  However, major challenges remain with on-going surplus capacity and extensive political uncertainty.

Headline inflation has increased over the past year in several countries, but moderated recently with the fall in energy prices.  Core inflation and long-term bond yields remain low.  Monetary policy is expected to remain stimulatory in the advanced economies, but less so going forward.

The trade-weighted exchange rate has increased by around 3 percent since May, partly in response to higher export prices.  A lower New Zealand dollar would help rebalance the growth outlook towards the tradables sector.

GDP growth in the March quarter was lower than expected, with weaker export volumes and residential construction partially offset by stronger consumption.  Nevertheless, the growth outlook remains positive, supported by accommodative monetary policy, strong population growth, and high terms of trade.  Recent changes announced in Budget 2017 should support the outlook for growth.

House price inflation has moderated further, especially in Auckland.  The slowdown in house price inflation partly reflects loan-to-value ratio restrictions, and tighter lending conditions.  This moderation is projected to continue, although there is a risk of resurgence given the on-going imbalance between supply and demand.

The increase in headline inflation in the March quarter was mainly due to higher tradables inflation, particularly petrol and food prices.  These effects are temporary and may lead to some variability in headline inflation.  Non-tradables and wage inflation remain moderate but are expected to increase gradually.  This will bring future headline inflation to the midpoint of the target band over the medium term. Longer-term inflation expectations remain well-anchored at around 2 percent.

Monetary policy will remain accommodative for a considerable period.  Numerous uncertainties remain and policy may need to adjust accordingly.

New Zealand’s financial system is sound but continues to face risks

New Zealand’s financial system remains sound and the risks facing the system have reduced in the past six months, Reserve Bank Governor Graeme Wheeler said today when releasing the Bank’s May Financial Stability Report.

“The outlook for the global economy has been improving but global political and policy uncertainty remains elevated and debt burdens are high in a number of countries. A sharp reversal in risk sentiment could lead to higher funding costs for New Zealand banks and an increase in domestic borrowing costs. New Zealand’s banks are vulnerable to these risks because of their increasing reliance on offshore funding for credit growth,” Mr Wheeler said.

“House price growth has slowed in the past eight months, in response to tighter loan-to-value ratio (LVR) restrictions, and a more general tightening in credit and affordability pressures in parts of the country.

While residential building activity has continued to increase, the rate of house building remains insufficient to meet rapid population growth and the existing housing shortage. House prices remain elevated relative to incomes and rents, and any resurgence would be of concern.

“Dairy prices have recovered significantly in the past 12 months, and the majority of dairy farms are likely to have returned to profitability in the 2016/17 season. However, parts of the dairy sector are carrying excessive debt burdens, and remain vulnerable to a fall in income or an increase in costs. Banks should continue to closely monitor and maintain full provisioning against lending to high risk farms,” he said.

Deputy Governor Grant Spencer said “The banking system maintains strong capital and funding buffers, and profitability remains robust. The banking system appears to be operating efficiently when compared with other OECD countries, based on metrics such as cost-to-income ratios, non-performing loans and interest rate spreads.

“Banks have generally tightened credit conditions in light of funding constraints and the increasing risks around housing. Banks are seeking to reduce their reliance on offshore funding and have raised deposit rates.

The Reserve Bank supports a cautious approach to managing foreign debt, in light of lessons learned in the GFC.

“While the LVR restrictions have increased the banks’ resilience to any fall in house prices, a significant share of housing loans are being made at high debt-to-income (DTI) ratios.

Such borrowers tend to be more vulnerable to any increase in interest rates or declines in income. There is evidence that borrowers with high DTI ratios are the most vulnerable to rising mortgage rates. At a mortgage rate of 7 percent, around half of existing borrowers with DTI ratios above 5 are expected to face severe stress. However, this represents just 3 percent of borrowers.

Overall, this analysis suggests that a significant proportion of New Zealand borrowers are vulnerable to a material increase in mortgage rates. A sharp and unexpected rise in mortgage rates could see the most vulnerable households default, sell their houses or reduce consumption to repay debt. Recent borrowers in Auckland and borrowers with high DTI ratios appear most vulnerable, signalling that a continued high share of lending at high DTI ratios is concerning and may present a risk to the housing market and financial stability.

The Reserve Bank will soon release a consultation paper proposing the addition of DTI restrictions to our macro-prudential toolkit.

“The Reserve Bank is making progress on a number of other initiatives.  A review of bank capital requirements is underway and we recently released an issues paper on the intended scope of the review. We recently concluded a review of the outsourcing policy for registered banks, and the Bank and other agencies are assessing the recommendations from the International Monetary Fund’s recent (FSAP) review of New Zealand’s financial system.”

RBNZ Official Cash Rate unchanged at 1.75 percent

The New Zealand Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent.

Global economic growth has increased and become more broad-based over recent months. However, major challenges remain with on-going surplus capacity and extensive political uncertainty.

Stronger global demand has helped to raise commodity prices over the past year, which has led to some increase in headline inflation across New Zealand’s trading partners. However, the level of core inflation has generally remained low. Monetary policy is expected to remain stimulatory in the advanced economies, but less so going forward.

The trade-weighted exchange rate has fallen by around 5 percent since February, partly in response to global developments and reduced interest rate differentials. This is encouraging and, if sustained, will help to rebalance the growth outlook towards the tradables sector.

GDP growth in the second half of 2016 was weaker than expected. Nevertheless, the growth outlook remains positive, supported by on-going accommodative monetary policy, strong population growth, and high levels of household spending and construction activity.

House price inflation has moderated further, especially in Auckland. The slowing in house price inflation partly reflects loan-to-value ratio restrictions and tighter lending conditions.
Despite ongoing strength in the fundamental drivers of housing demand,namely population growth and low mortgage interest rates, housing activity has slowed since mid-2016. This likely reflects a range of factors,including changes to LVR policy, and increases in mortgage rates in 2016, and increasing pressure on affordability. This moderation is projected to continue, although there is a risk of resurgence given the continuing imbalance between supply and demand.

Mortgage rates have stabilised since the February Statement,with reduced upward pressure from lower wholesale interest rates (figure 4.5). Mortgage rates remain at low levels relative to history, but recent changes to LVR policy have tightened credit availability for some households. Lending conditions for residential property development have tightened.
The increase in headline inflation in the March quarter was mainly due to higher tradables inflation, particularly petrol and food prices. These effects are temporary and may lead to some variability in headline inflation over the year ahead. Non-tradables and wage inflation remain moderate but are expected to increase gradually. This will bring future headline inflation to the midpoint of the target band over the medium term. Longer-term inflation expectations remain well-anchored at around 2 percent.

Developments since the February Monetary Policy Statement on balance are considered to be neutral for the stance of monetary policy.

Monetary policy will remain accommodative for a considerable period. Numerous uncertainties remain and policy may need to adjust accordingly.

RBNZ Reviews Capital Adequacy Framework

The New Zealand Reserve Bank has announced it is undertaking a comprehensive review of the capital adequacy framework applying to locally incorporated registered banks over 2017/18. The aim of the review is to identify the most appropriate framework for setting capital requirements for New Zealand banks, taking into account how the current framework has operated and international developments in bank capital requirements.

The Capital Review will focus on the three key components of the current framework:

  • The definition of eligible capital instruments
  • The measurement of risk
  • The minimum capital ratios and buffers

The purpose of this Issues Paper is to provide stakeholders with an outline of the areas of the capital adequacy framework that the Reserve Bank intends to cover in the Capital Review, and invite stakeholders to provide initial feedback on the intended scope of the review, and issues that might warrant particular attention. As feedback is received and decisions are made, some of these issues might fall away or be given a lower priority.

Detailed consultation documents on policy proposals and options for each of the three components will be released later in 2017, with a view to concluding the review by the first quarter of 2018.

Basis and framework for capital regulation

The Reserve Bank has powers under the Reserve Bank Act 1989 to impose capital requirements on registered banks. The Reserve Bank exercises these powers to promote the maintenance of a sound and efficient financial system, and to avoid significant damage to the financial system that could result from the failure of a registered bank.

The capital adequacy framework for locally incorporated registered banks is set out mainly in documents BS2A and BS2B of the Reserve Bank’s Banking Supervision Handbook. The framework is based on, but not identical to, an international set of standards produced by the Basel Committee on Banking Supervision.

The framework imposes minimum capital ratios. These are ratios of eligible capital to loans and other exposures. Exposures are adjusted (risk-weighted) so that more capital is required to meet the minimum requirement if the bank has riskier exposures.

The high-level policy options raised in this Issues Paper have the potential to result in reasonably significant changes to the New Zealand capital framework. It is expected, however, that any changes are likely to occur within a Basel-like framework.

The Reserve Bank invites submissions on this Issues Paper by 5pm on 9 June 2017

RBNZ Official Cash Rate unchanged at 1.75 percent

The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent.

Macroeconomic indicators in advanced economies have been positive over the past two months.  However, major challenges remain with on-going surplus capacity in the global economy and extensive geo-political uncertainty.

Global headline inflation has increased, partly due to a rise in commodity prices, although oil prices have fallen more recently.  Core inflation has been low and stable. Monetary policy is expected to remain stimulatory, but less so going forward, particularly in the US.

The trade-weighted exchange rate has fallen 4 percent since February, partly in response to weaker dairy prices and reduced interest rate differentials.  This is an encouraging move, but further depreciation is needed to achieve more balanced growth.

Quarterly GDP was weaker than expected in the December quarter, but some of this is considered to be due to temporary factors.  The growth outlook remains positive, supported by on-going accommodative monetary policy, strong population growth, and high levels of household spending and construction activity.  Dairy prices have been volatile in recent auctions and uncertainty remains around future outcomes.

House price inflation has moderated, and in part reflects loan-to-value ratio restrictions and tighter lending conditions.  It is uncertain whether this moderation will be sustained given the continued imbalance between supply and demand.

Headline inflation has returned to the target band as past declines in oil prices dropped out of the annual calculation.  Headline CPI will be variable over the next 12 months due to one-off effects from recent food and import price movements, but is expected to return to the midpoint of the target band over the medium term. Longer-term inflation expectations remain well-anchored at around 2 percent.

Monetary policy will remain accommodative for a considerable period.  Numerous uncertainties remain, particularly in respect of the international outlook, and policy may need to adjust accordingly.

Headline inflation has returned to the target band as past declines in oil prices dropped out of the annual calculation.  Headline CPI will be variable over the next 12 months due to one-off effects from recent food and import price movements, but is expected to return to the midpoint of the target band over the medium term. Longer-term inflation expectations remain well-anchored at around 2 percent.

Monetary policy will remain accommodative for a considerable period.  Numerous uncertainties remain, particularly in respect of the international outlook, and policy may need to adjust accordingly.