Reserve Bank concedes its monetary policy was ‘too stimulatory’ during pandemic response

The Reserve Bank (RBNZ) has conceded that its monetary policy was “too stimulatory” at some stage during the response to the pandemic. But it appears to be laying the blame for its inability at the time to take the Official Cash Rate (OCR) into the negatives.

The rare admission of fault by the central bank comes in a background paper that outlines why the RBNZ went down the quantitative easing (QE) path, deploying the Large Scale Asset Purchases (LSAP) and Funding for Lending Program (FLP) as part of its monetary policy response to Covid-19. The paper also outlines a framework for assessing the impacts of these programs.

The LSAP program saw the RBNZ buy about $ 53 billion of government bonds – which are now being sold back to Treasury at a rate of $ 5 billion per year – while the FLP, which allows banks to borrow at the Official Cash Rate, has so far been utilized to tune of $ 12.7 billion. The FLP officially ends in December.

The RBNZ effectively indicates it had to go down the path of QE due to the unpreparedness of the banking system for a negative OCR. It appears to imply that a negative OCR would be the preferred path in future.

“The OCR remains the most effective tool for managing the overall level of monetary stimulus through economic cycles. The banking system is now in a position to accommodate negative interest rates, and this will form part of the monetary policy toolkit in future,” the RBNZ said.

The background paper notes that consumer price inflation is above the RBNZ’s target range.

“Estimates of core inflation, which measure the persistent component of inflation, range between 4% and 6% per annum, well outside of the 1% -3% inflation target range.

“With the benefit of hindsight, this indicates that monetary policy was too stimulatory at some stage during the tumultuous economic period of the pandemic. In response, the OCR is now above its neutral rate until domestic demand better matches the supply capacity of the New Zealand economy. “

The RBNZ hiked the OCR by another 50 basis points on Wednesday this week to a seven-year high of 3%. The cash rate has been hiked by 225 basis points this year with probably at least another 75 to come before the end of this year.

In the background paper, the central bank said the “pattern” in monetary policy settings it had followed was “a global phenomenon” and had occurred in many other countries around the world since the onset of the pandemic.

“There will be important lessons in this for the RBNZ – captured in our forthcoming review – and for domestic and international policymakers more generally.”

The RBNZ is current undertaking a detailed assessment of its monetary policy actions over the past five years, as required by the Reserve Bank Act (2021). The bank says that to ensure this assessment is fair and transparent, it will be externally peer reviewed by two international experts on monetary policy.

“The RBNZ aims to learn as much as possible from this review, which will provide a balanced assessment of the net benefits of RBNZ’s monetary policy actions over the past five years. The RBNZ will publish this work towards the end of 2022.”

The background paper notes that “importantly”, during the period of “extreme economic uncertainty” in 2020, the RBNZ’s Monetary Policy Committee – which sets monetary policy at the RBNZ – “clearly communicated that there could be some ‘policy regret’ in future, given the circumstances “.

“Managing future high inflation down, rather than dealing with deflation and economic depression, was considered to be the ‘least bad’ regret, if one was forced to choose.

“We are now well advanced in tightening monetary policy to manage inflation down into the RBNZ’s target range, having avoided economic depression, deflation, and unnecessary high unemployment.”

The RBNZ said the net benefits of it deploying its monetary policy tools also need to account for the risks associated with the policy action relative to the case of no action. “While difficult to quantify, Table 5 offers a brief assessment of the risks associated with the deployment of the LSAP and FLP.”

The RBNZ said that exploratory work done in 2019 had found that many of New Zealand’s commercial banks “were not operationally ready” to manage negative interest rates, should they be required.

“This raised serious concerns about any unintended impacts of a negative OCR on the efficient functioning of the New Zealand financial system. With the OCR near its effective lower bound (near zero), the RBNZ began developing additional monetary policy tools. The RBNZ also instructed commercial banks to prepare themselves for a negative OCR, should that be required in future.

“With further cuts to the OCR constrained, ‘quantitative’ tools – such as the ‘Large Scale Asset Purchase Program’ – became increasingly necessary as options for implementing monetary policy.

“By early 2020, with the global onset of the COVID-19 pandemic, the need to deploy additional monetary policy tools became increasingly apparent. With the OCR at its practical limit, additional ways of providing monetary stimulus were required if the RBNZ was to achieve its monetary policy and financial stability goals. ”

The RBNZ said its modeling shows that while OCR cuts “were clearly critical”, the LSAP and (less so) FLP were “also key” in lowering interest rates and loosening overall monetary conditions.

“By using LSAP and FLP, the RBNZ was able to provide additional monetary support and financial market stability to New Zealanders, even when the OCR couldn’t be lowered due to operational constraints in the financial sector.”

While it is “extremely difficult” to isolate the individual economic impacts of LSAP and FLP, lower interest rates brought about by accommodative monetary policy were fundamental in supporting economic activity over the pandemic, the RBNZ says.

“RBNZ actions led to higher than otherwise aggregate spending, investment, employment, profits, and tax revenue in the economy. Lower interest rates along the yield curve also put downward pressure on the exchange rate, contributing to improved net export revenues. Unemployment, business failures, welfare expenditure and long-term economic scarring were all lower than they otherwise would have been.

“In addition, the return of liquidity and stability in the government bond market promoted broader financial stability, enabling ‘business as usual’ activity for government and firm capital raising and financial intermediation. All this was achieved despite the continued extreme economic uncertainty associated with an unprecedented global pandemic. “