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New Zealand Economic and Financial Overview 2010

Monetary Policy

Objectives

The Reserve Bank of New Zealand Act 1989 stipulates that the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices. The Act requires that there be a Policy Targets Agreement (PTA) between the Minister of Finance and the Governor of the Reserve Bank. The most recent PTA was signed in December 2008 after the new government took office. There were no substantive changes to the Agreement. For the purpose of the PTA, the policy target is to keep future CPI inflation outcomes between 1% and 3% on average over the medium term.

Section 3 of the PTA notes that there is a range of events that will cause the actual rate of CPI inflation to vary about its medium-term trend. When such disturbances occur, the Bank is tasked with responding in a manner consistent with meeting its medium-term target.

The PTA requires the Bank, in pursuing the price stability target, to seek to avoid unnecessary instability in output, interest rates and the exchange rate and to implement policy in a sustainable, consistent and transparent manner.

The Reserve Bank Act provides the Bank with a considerable degree of autonomy to carry out the price stability objective. However, the Act contains certain provisions that enable the government to override the price stability objective and the PTA, provided this is done in accordance with a set of procedures that would make the override publicly transparent.

Implementation

The OCR is the interest rate set by the Reserve Bank to meet the inflation target specified in the Policy Targets Agreement. The OCR influences the price of borrowing money in New Zealand and provides the Reserve Bank with a means of influencing the level of economic activity and inflation. The OCR is a fairly conventional tool by international standards.

The OCR was introduced in March 1999 and is reviewed eight times a year by the Bank. The Bank issues "Monetary Policy Statements" with the OCR announcement on four of these occasions. Unscheduled adjustments to the OCR may occur at other times in response to unexpected or sudden developments but, to date, this has occurred only once - following the 11 September 2001 attacks in the United States.

During 2006, the Bank moved to a new liquidity management regime. Under the regime, the Reserve Bank sets no limit on the amount of cash it will borrow or lend at rates related to the OCR. The Bank stands ready to lend cash overnight at 50 basis points above the OCR when secured over government liabilities in its overnight reverse repurchase facility. Overnight balances in exchange settlement accounts are remunerated at the OCR.

The Bank publishes an assessment of economic conditions at quarterly intervals in its Monetary Policy Statements. The Statements contain projections that incorporate a forward path for interest rates that is consistent with achieving the inflation target. These projections are highly conditional, being based on a range of technical assumptions, but they serve to provide some indication of the Bank's current thinking on the policy outlook.

From 2004 until mid-2008, monetary policy was in a tightening phase with the Reserve Bank increasing the OCR by a total of 325 basis points from 5.0% in January 2004 to a peak of 8.25% in July 2007. The policy tightening reflected a prolonged period of strength in the domestic economy which left productive resources stretched and led to a rise in non-tradable inflation.

Following a long period of growth, economic activity began to decline in the first quarter of 2008. Initially this reflected three concurrent shocks: a correction in the housing market, sharply rising commodity prices and drought over much of the country. The global credit crisis exacerbated the decline in economic activity with real GDP declining a cumulative 3.3% in the five quarters to March 2009. Modest growth of 0.2% was recorded in the June and September quarters 2009.

Annual CPI inflation declined from 5.1% in the September 2008 quarter (a result due principally to high international oil and food prices) to 2.0% in the December 2009 quarter. Reflecting the worsening international financial crisis and the consequent outlook for economic activity and inflation, the Reserve Bank reduced the OCR from 8.25% to 2.50% between July 2008 and April 2009.

At its most recent policy announcement in January 2010, the Reserve Bank left the OCR unchanged at 2.5%. The economy is believed to be growing again but the after-effects of the financial crisis are expected to weigh on growth for some time to come. As a result, the Bank said it expected to keep the OCR at 2.5% until the second half of 2010. Annual CPI inflation is expected to continue to remain comfortably within the target range over the medium term.

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