Given our central bank's increased emphasis on preserving financial stability, it might be time to look again at its official remit

By David Hargreaves

Is it time for a comprehensive overhaul of the Reserve Bank of New Zealand Act 1989?

I ask that as a genuine question rather than some cleverly intended rhetoric, because I'm actually unsure. Please bear with me while I have a debate and feel free to chip in.

My reason for posing the question about perhaps more clearly defining publicly the role of the RBNZ as it stands in 2015 is because, certainly in my view, New Zealand's interest rates are currently too high when compared globally.

If you recall, our official rates, as defined by the Official Cash Rate (OCR) were fairly aggressively jacked up last year to the current 3.5% from 2.5% at the start of 2014. In basic terms the rises were in response to anticipated higher levels of inflation and to perceived upward moves in rates elsewhere - primarily the US.

Well, 12 months on and we are closer to deflation than inflation (sagging oil prices and an on-steroids Kiwi dollar have helped), while interest rate rises in the US are still on the table, but the table appears to be slowly moving further away.

High rates

Our interest rates are now way higher than those in Australia, where the official rates are at 2.25%, with a better than even chance of being reduced to 2% next month.

Logic would therefore suggest a drop in our rates of at least half a percentage point, back to 3%, right now. But as we know, that's not happening, though I would say that RBNZ Assistant Governor John McDermott's speech last week has prepared the groundwork for a dropping of rates to that 3% level late this year - assuming global and national economic conditions stay pretty much where they are at the moment.

What the RBNZ doesn't say - though it's what the 'market' certainly thinks - is that we are not getting lower interest rates right now because of the overheating state of the Auckland housing market.

And that's where it gets pretty interesting.

The targeting of inflation is a 'monetary policy' issue. Auckland house prices - in the way we are currently observing them - are a 'financial stability' issue. Normally the RBNZ makes a clear definition between the two, but right now I think the two are becoming intertwined and muddied.

Galloping prices

Rising house prices certainly can be a monetary policy issue. But remember, house prices of themselves are not included in the Consumer Price Index. Where galloping house prices become an inflation issue is when they (as typically has been the case in the past) start feeding into rising prices of building materials, labour etc and into consumer inflation expectations.

None of these things are happening right at the moment.

So, the misbehaving Auckland housing market can at this stage be viewed purely as a financial stability problem. And don't take from that expression that I'm under-selling the gravity of the problem, because if there was a sudden house price shock led by Auckland it would be truly ugly for our banks and our economy.

But financial stability problem it is. And so why is the RBNZ keeping interest rates up (monetary policy) for implicit fear of the bucketload of petrol that a drop in rates would apply to the Auckland market (financial stability)? Hmmm...

You see, I get the increasing feeling that there's a developing public tension between the varying operations of our central bank. So, the whole issue might benefit from people in high places all sitting back for a bit and having a good look at just what the country wants and expects from its central bank.

In on the Act

The 1989 RBNZ legislation, which was really quite ground-breaking in its time, set the framework for which the RBNZ was focused on the goal of "price stability". Once upon a time the RBNZ's monetary policy had a few targets and this all became rather confusing really, but after the 1989 legislation (enacted in 1990) we got the sole aim from monetary policy of "price stability", which in english meant as close to no inflation as possible.

The purpose of the Act as it stands at the moment provides for the RBNZ, as the central bank, to be responsible for:

1. formulating and implementing monetary policy designed to promote stability in the general level of prices, while recognising the Crown’s right to determine economic policy;
2. promoting the maintenance of a sound and efficient financial system; and
3. carrying out other functions, and exercising powers, specified in the Act. 

In Part 2 of the Act, under "Functions and powers of Reserve Bank" the first stated of these powers is to "act as central bank". This is closely followed by "monetary policy", in which it is stated:

"The primary function of 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."

Catch 22

A bit further on there's then what I might construe as a bit of a "catch 22" clause, which states:

"In formulating and implementing monetary policy the Bank shall — (a) have regard to the efficiency and soundness of the financial system..."

I take this to mean that financial stability can become the scissors to monetary policy's paper. In other words if something might impact financial stability then monetary policy might need amending.

But I think we probably now need a stronger point of difference between monetary policy and financial stability - and more explicitly expressed.

It seems clear enough that financial stability issues have become a much stronger focus - and concern - for our central bank than they were in 1989.

Financial stability

The important set-piece public events for the RBNZ every year are the six-weekly reviews of the Official Cash Rate and the twice-yearly Financial Stability Report. The first Financial Stability Report was in fact not published till 2004, with the then Governor Alan Bollard stating: “This new six monthly publication reflects the increased emphasis that the Reserve Bank is placing on financial stability issues. We are seeking to ensure that New Zealanders can have the benefits of a financial system that is both sound and efficient.”

So, "increased emphasis" back in 2004. And, let's not forget, in 2008 there was the small matter of the Global Financial Crisis - from which the big four Australian (also our) banks emerged fortunately as strong as oxes. But there's no doubt that a near-global extinction event such as happened less than seven years ago was a clear portent to the kind of increased vigilance now occurring, and needed, from central banks.

It appears to me that, in a way, the RBNZ is pushing ahead with increasing financial stability measures (and such things as the macro-prudential tools fall into this category), whilst not being specifically sanctioned to do so - not in terms of its empowering legislation anyway, and notwithstanding that the macro-prudential tools were agreed with the Minister of Finance.

Spell it out

What I'm trying to say then is that we seem to have reached a point where perhaps the principal purpose of the RBNZ needs to be clearly spelt out as protecting financial stability first - and with other things spinning off that, including monetary policy.

As things stand at the moment, it can be anticipated that unless the RBNZ can point pretty soon to some rising medium term inflation, it is going to have the Government on its case about a potential change in monetary policy targets because that's what the rules say can happen.

The Government will, no doubt, be pushing for those lower interest rates.

It seems clear that what the RBNZ wants is to bring in more targeted measures against the housing market (possibly through its macro-prudential toolkit) and then move interest rates lower once these are introduced - IE control the house fire before the petrol can is put anywhere near it. So, I reckon you would be looking at around September-October for both of these things to happen.

If the RBNZ had financial stability as its primary mandate, it would not have to worry about finessing such a balancing act between public and Government expectations and doing what it thinks is best for the financial wellbeing of the country.

So, to go back to the beginning; is it time for an overhaul of the Reserve Bank Act?