5.4 Interest rates
The current framework in New Zealand means that the central bank sets monetary policy using the official cash rate as the policy instrument to adjust the short-term nominal interest rate (rcs). This adjustment in turn affects the slope of the yield curve (rcs-rl).[18] In setting monetary policy, the central bank looks forward at an equally weighted average of the fifth through seventh leads of the deviation of annual inflation from the central bank's target (cpi_tar; currently 2%). The focus on the fifth through seventh leads of annual inflation reflects the medium-run focus of inflation targeting in New Zealand. Equation (5.4.1) also contains a term representing the difference between the 90 day bill rate and its lag to reflect how the central banks set monetary policy under uncertainty. In the presence of full information about the future, the central bank would set the policy rate at a rate that would achieve its inflation target. However, in the absence of full information the central bank is more risk averse and avoids extreme changes in interest rates - the lag term in (5.4.1) helping to achieve this dynamic.
where
and
10-year bond rates (rl) are determined using the term structure of interest rates (see the discussion in section 5.2 on inflation expectations).
Notes
- [18]See Black et al. (1997) for an explanation of the advantages of using the yield curve specification.
