RBNZ Consults On Revised Capital Adequacy Changes

The Reserve Bank NZ, has issued a Consultation Paper: Review of the Capital Adequacy Framework for locally incorporated banks: calculation of risk weighted assets.

This is the third consultation document of the review. The first document provided an overview of the review. The second document considered the definition of capital, which is the numerator in the minimum regulatory capital ratio. This document is concerned with the denominator in the minimum capital ratio, which is effectively a measure of exposure to risk.

They highlight further issues with the internal calculation method, as well as recent changes from the Basel Committee.

There is international and New Zealand evidence that minimum capital requirements went down significantly after banks were permitted to use their internal models for parts of the capital calculation. There is also international evidence that internal model outcomes are inconsistent. Different banks often come up with similar rankings of risk but the absolute levels of risk are substantially different even for the same obligors. The evidence is clearest in the case for exposures to governments, banks, and large corporations, but there is also some evidence of problems in other portfolios such as residential mortgages and SME lending.

The Basel Committee had proposed to replace the IRB approach with the standardised approach for bank and large corporate exposures, and with a standardised or semi-standardised approach for all specialised lending to corporates. The finalised framework did not go this far – it continues to allow a more limited form of IRB modelling, the Foundation IRB (F-IRB) approach, for bank and large corporate exposures. The new framework does, as originally proposed, constrain the outputs of internal models and impose an overall floor – based on the risk assessed under the standardised approach – on the average risk weight, to prevent it from straying too far from a common level.

Specifically, there are currently significant differences between the two approaches. Banks with internal models have a significant capital advantage.

They table options for both internal and standard approaches, as below.


Will APRA Loosen Lending Standards Next Year?

Interesting economic summary from Moody’s. They recognise the problem with household finances, and low income growth. They also suggest, mirroring the Reserve Bank NZ, that macroprudential policy might be loosened a little next year.

I have to say, given credit for housing is still running at three times income growth, and at very high debt levels, we are not convinced! I find it weird that there is a fixation among many on home price movements, yet the concentration and level of household debt (and the implications for the economy should rates rise), plays second fiddle.

Also, the NZ measures were significantly tighter, and the recent loosening only slight (and in the face of significant political measures introduced to tame the housing market). So we think lending controls should be tighter still in 2018.

It’s strange examining third quarter data when the fourth stanza has almost passed, but the Australian Bureau of Statistics isn’t known for timely national accounts data. Australia is the last major Asia-Pacific economy to release quarterly GDP numbers. Despite the tardiness, the national accounts gives valuable insight, especially on the investment front in the absence of a reliable monthly gauge.

Australia’s GDP growth hit 0.6% q/q in the September quarter following an upwardly revised 0.9% (previously reported as 0.8%) gain in the June stanza. Annual growth accelerated to 2.8% from the prior 1.8% gain. The annual growth figure is now hovering at potential, which we estimate is around 3%. However, momentum is overstated, given low base effects. In the September quarter of 2016, the Australian economy contracted by 0.5% q/q, only the fourth quarterly contraction in 25 years. This was driven by a sharp fall in investment alongside higher imports. During this period, annual growth slowed by 1.3 percentage point to 1.8%.

Private investment booms

Private investment was a bright spot in the third quarter because of a sharp rise in non-dwelling construction, which made the largest contribution to GDP growth at 0.9 percentage point.

Non-dwelling construction has often become a proxy for mining investment, and the third quarter gain is likely due to the installation of two liquefied natural gas platforms in Western Australia and the Northern Territory. LNG exports are expected to pick up late in the fourth quarter amid increased production capacity. The Wheatstone project began production earlier in October after a two-year construction phrase and
shipped its first export to Japan late in the month. Wheatstone is the sixth of eight projects included in a A$200 billion LNG construction boom that is now in its final stretch. Once the remaining two projects are finalized, Australia could topple Qatar as the world’s biggest LNG exporter. Australia has recently become the world’s second largest exporter of LNG.

Public investment didn’t score as well in the third quarter, declining by 7.5% q/q. This is mainly payback after a boost in the June quarter from the acquisition of the Royal Adelaide Hospital from the private sector.

The housing market has cooled in 2017, and price growth is expected to keep decelerating through 2018; this will keep downward pressure on dwelling investment. For instance, dwelling price growth in Sydney was 5% y/y in November, well down from its double-digit growth in 2016 and earlier in 2017.

This is the result of the lagged impact of earlier macroprudential action that has included higher borrowing costs for homebuyers, especially investors or those taking out interest-only loans. The Australian Prudential Regulation Authority has also imposed limits on bank portfolio exposure to new mortgages.

Owner-occupied housing finance commitments tend to track house price growth and are a good gauge of the underlying pulse. Data released this week show October commitments rose just 0.3% m/m on a trend basis. Growth has slowed substantially from earlier in 2017.

An interesting tidbit we have observed in recent years: Housing regulation in New Zealand tends to lead Australia’s by at least a year. The Reserve Bank of New Zealand was on the front foot trying to cool certain heated housing pockets such as Auckland well before the Australian Prudential Regulation
Authority introduced housing-targeted measures, even though both economies were experiencing strong price growth in some areas. Just recently, the RBNZ announced it had eased some macroprudential measures in light of softer house price growth. Now that Australia’s housing market has cooled, APRA may follow suit with minor reversals in the next year.

Households missing in action

At first glance it was a relief that consumption made a positive contribution to GDP growth, but the details were less pleasing, as spending was concentrated on essential items while discretionary purchases suffered. We calculated that nondiscretionary items rose an average 0.6% over the quarter, and discretionary spending fell by 0.7%.

Of the nondiscretionary items, utility spending rose 1.4% q/q, food was up 1%, rent gained 0.6%, and insurance and financial services grew 1.3%. On the discretionary front, clothing spending fell 1% q/q, recreation and culture was down 0.6%, and spending at cafes and restaurants fell by 0.9%.

All told, softness in the consumer sector was largely masked by spending on nondiscretionary items. The monthly retail trade data do not capture nondiscretionary spending as thoroughly as the national accounts; over the third quarter retail volumes were up just 0.1% q/q.

We know from earlier testing that consumer sentiment does not have a causal relationship with retail spending, but incomes do. Sentiment is a symptom of weak income growth, rather than a forward indicator of spending behaviour. The Westpac consumer sentiment index fell to 99.7 in November, below the neutral 100 that indicates optimists equal pessimists. Overall, consumers have been downbeat through most of 2017, concerned about family finances and the economic outlook. At 2% y/y, income growth is hovering near a record low, so it’s little surprise households have pulled
back on discretionary purchases, while other costs such as utilities rose in the third quarter because of seasonal price hikes. The net household saving ratio rose to 3.2% in the third quarter, higher than the decade low of 3% in the June quarter, suggesting that consumers aren’t willing to keep dipping into their savings to fund discretionary purchases. It’s concerning that household consumption is weak, given that it constitutes 75% of GDP.

Businesses are faring better than consumers at the moment. This is reflected in soaring private investment, lofty gains in company profits, and strong employment growth, particularly full-time, through 2017. Unfortunately, this has not yet flowed through to stronger income growth, and there are likely several factors at play. The first is cyclical: Low productivity is mooted as a reason for benign wages in the developed world. More Australia-specific is that underemployment has been very high in
Australia and the correlation with income growth is around -0.88. Underemployment has started to edge lower as full-time positions outpace part-time, and our baseline scenario is for the tighter labour market to yield stronger income growth by mid-2018. Although Australia’s Phillips curve has flattened in the past decade, there is still a reasonable relationship between unemployment and income growth.

Some structural factors: The rise of the gig economy has contributed to the rise in casual employment. These positions are more flexible and more easily adapt to changing demand, but there’s no union representation, which can hurt wage bargaining. Also, as the positions are more flexible, there’s more acceptance that lower wages can be a consequence.

Another structural reason for low incomes could be the higher prevalence of offshoring roles. There’s no reliable industry- or economy-wide data measuring the extent of offshoring, but we know that it is an unrelenting phenomenon, given the disparity in operating costs between Australia and the developed world. Employers are not locally replacing jobs lost offshore, so they are not potentially driving up labour costs to secure the appropriate candidate.

All told, these structural factors suggest that national income growth is unlikely to enjoy a significant rebound but rather gradual and modest improvement in 2018.

How’s the fourth quarter tracking?

Our high-frequency GDP tracker suggests a 2.7% y/y expansion in the December quarter following the barrage of October activity data this week. Retail trade came in at a strong 0.5% m/m, although this was payback for sustained weakness through the third quarter, when retail turnover fell an average 0.3% m/m.

October foreign trade data weren’t inspiring, as merchandise exports fell by 2% m/m amid lower iron ore prices and, to a lesser extent, volumes. The iron ore spot price increased by 22% from its late-October slump to US$71.51 per metric tonne in early December. We expect this will enable iron ore export receipts to improve heading into 2018 as higher global prices are incorporated into contracts; usually the lag is short. It’s too early to determine whether volumes will be adversely affected by higher prices.

We maintain our view that monetary tightening is firmly off the table for at least another year as the central bank sits on the sidelines waiting for consumption to show meaningful signs of a pickup. Our expectation is that the Australian dollar will depreciate around an additional 3% against the U.S. dollar over the next six months, serving to encourage more  consumption onshore and lift export competitiveness and helping core inflation return to and creep through the central bank’s 2% to 3%
target range.

Reserve Bank NZ to ease LVR restrictions

The Reserve Bank NZ has announced a slight reduction in tight loan to value lending controls, in response to the slowing housing sector and Government policy.  The loan-to-value ratio (LVR) policy was first introduced in October 2013, with progressively tighter restrictions for investors introduced in November 2015 and October 2016.

New Zealand’s financial system remains sound and risks to the system have reduced over the past six months, Reserve Bank Governor Grant Spencer said today when releasing the Bank’s November Financial Stability Report.

“Momentum in the global economy has continued to build over the past six months, reducing near-term risks to financial stability. However, the New Zealand financial system remains exposed to international risks related to elevated asset prices and high levels of debt in a number of countries.

“Domestically, LVR policies have been in place since 2013 to address financial stability risks arising from rapid house price inflation and increasing household debt. These policies have helped improve banking system resilience by substantially reducing the share of high-LVR loans. Over the past six months, pressures in the housing market have continued to moderate due to the tightening of LVR restrictions in October 2016, a more general firming of bank lending standards and an increase in mortgage interest rates in early 2017.

If there was a major housing market correction or economic downturn, then this reduction in the share of lending at high LVRs is likely to mean that fewer housing loans would default, and overall bank losses would be lower. One way of quantifying this is to use data from recent stress tests to estimate how the change in banks’ portfolios would affect default and loss rates for a given downturn scenario. Based on the 2017 stress test scenario we estimate that banks would experience around 10 percent lower default rates and around 20 percent lower credit loss rates than they would have if LVR restrictions had not been applied .

In the media conference the bank said $54bn of new OO were written over the past year, but there is no data on the number of additional applications which may flow now. They expect some increase in new loans at higher LVR’s but as the banks use their own buffers the bank is not expecting a large rise, but it could benefit first time buyers. They called this an incremental change, and they will continue to review the LVR restrictions – there is no schedule to move to no restrictions.  This is also a reaction to Government policies which will cool the market. They expect property investors to remain on the “back foot”, with lower future price gains now observed.

“Housing market policies announced by the Government are also expected to have a dampening effect on the housing market.

“In light of these developments, the Reserve Bank is undertaking a modest easing of the LVR restrictions. From 1 January 2018, the LVR restrictions will require that:

  • No more than 15 percent (currently 10 percent) of each bank’s new mortgage lending to owner occupiers can be at LVRs of more than 80 percent.
  • No more than 5 percent of each bank’s new mortgage lending to residential property investors can be at LVRs of more than 65 percent (currently 60 percent).

“The Bank will monitor the impact of these changes and will only make further LVR adjustments if financial stability risks remain contained. A cautious approach will reduce the risk of resurgence in the housing market or deterioration in lending standards.

Deputy Governor Geoff Bascand said “Looking at the financial system more broadly, the banking system maintains adequate buffers over minimum capital requirements and appears to be performing its financial intermediation role efficiently. The recovery in dairy commodity prices since mid-2016 has supported farm profitability and has helped to reduce bank non-performing loans in the sector. Recent stress tests suggest that banks are well positioned to withstand a severe economic downturn and operational risk events.

“The Bank has released two consultation papers on the review of bank capital requirements and a third paper on the measurement and aggregation of bank risk will be released shortly. The aim of the capital review is to ensure a very high level of confidence in the solvency of the banking system while minimising complexity and compliance costs.

“The Bank has also completed a review of the bank directors’ attestation regime and is making good progress in implementing a new dashboard approach to quarterly bank disclosures. This is expected to go live next May,” Mr Bascand said.

RBNZ Backs Supply Not DTI To Address Housing Risks

The Reserve Bank New Zeland has today published the Response to submissions on the Consultation Paper: Serviceability Restrictions as a Potential Macroprudential Tool in New Zealand.

Given the current slowdown in the housing market, the Reserve Bank considers a serviceability restriction would not be appropriate at present, but could still have a role to play in the future. In particular, the Reserve Bank does not believe DTI restrictions should be deployed in the current housing market environment and considers that the key longer term solution to housing market imbalances is to facilitate growth in housing supply in areas that need it.

In the meantime, they will continue to work with banks to improve the data being received on DTIs. The Reserve Bank is aware that system issues mean data from some banks includes overstated DTI ratios for some customers, and would like this to be gradually improved. The Reserve Bank may also provide further guidance around technical areas such as treatment of guarantees.

This is significant because many of the responses were from lenders who also operate in Australia, so we get a read on their arguments, ahead of the expected APRA paper on mortgage risk.  Good DTI data is a problem, but one which could and should be sorted.

This is interesting also, given the broader use of DTI in other jurisdictions (such as the UK) and the view expressed by IMF that DTI should be the macroprudential tool of choice.

Falling back to supply side issues squibs the core demand issues, in our view.

The NZ Reserve Bank received 25 submissions. A majority of submissions that expressed a clear view were against serviceability restrictions being added to the Reserve Bank’s toolkit. On the other hand, there were supportive submissions, and some submissions which went further and suggested serviceability instruments such as a debt-to-income ratio (DTI) restriction should be immediately deployed (not just added to the macroprudential toolkit set out in the MoU as the Reserve Bank had proposed).

Many submissions stated that loan-to-value ratio (LVR) restrictions are currently having a significant effect on the housing market and mortgage lending. Others said with mortgage rates rising recently and the housing market softening, DTI restrictions are not needed now.

Submitters expressed a range of views on whether house prices are currently overvalued. Some submissions stated that supply is the best way to correct imbalances and that LVR or serviceability restrictions cannot permanently solve housing market imbalances.

A number of submissions noted that banks’ own serviceability policies have tightened recently. Some noted that New Zealand consumer law (Credit Contracts and Consumer Finance Act 2003 (CCFA) and the related Responsible Lending Code (RLC)) requires lenders to undertake serviceability assessments. Some banks with Australian parents submitted that they are subject to the Australian Prudential Regulation Authority’s (APRA) prudential practice guide on residential mortgage lending, APG 223.2 Both the RLC and APG 223 require lenders to take the risk of rising interest rates into account when deciding if lending will be affordable.

Most of these points were consistent with the Reserve Bank’s views in the consultation paper. In particular, the Reserve Bank does not believe DTI restrictions should be deployed in the current housing market environment, and considers that the key longer term solution to housing market imbalances is to facilitate growth in housing supply in areas that need it.

We also acknowledged in the consultation paper that banks already undertake serviceability assessments and allow for the risk of rising interest rates. However, the Reserve Bank remains of the view that individual bank lending decisions may fail to take account of their impact on systemic risk during periods of intense competition for mortgage loans, and that there can be a role for limits on banks’ serviceability practices during these periods.

RBNZ Looks At Crypto-currencies

The Reserve Bank in New Zealand has released an excellent Analytical Note on Crypto-currencies “Crypto-currencies – An introduction to not-so-funny moneys“. It is one of the best I have read, so far!

The paper introduces the distributed ledger technology of crypto-currencies. They aim to increase public understanding of these technologies, highlight some of the risks involved in using crypto-currencies, and discuss some of the potential implications of these technologies for consumers, financial systems, monetary policy and financial regulation.

Crypto-currencies have no physical existence, but are best thought of as electronic accounting systems that keep track of people’s transactions and hence remaining purchasing power. Cryptocurrencies are typically decentralised, with no central authority responsible for maintaining the ledger and no central authority responsible for maintaining the code used to implement the ledger system, unlike the ledgers maintained by commercial banks for example. As crypto-currencies are denominated in their own unit of account, they are like foreign currencies relative to traditional fiat currencies, such as dollars and pounds.

They conclude that Crypto-currencies offer some distinct features, such as quicker cross-border transactions, possibly lower transaction fees, pseudo-anonymity, and transaction irreversibility. These features help to explain the growing demand for crypto-currencies, even though they fail to satisfy many of the basic functions of money.

Most crypto-currency accounts lie dormant and many of the active accounts are used only for online gambling or speculative purposes. Perceptions of anonymity have also created a demand for such currencies to facilitate illegal transactions, but the anonymity embodied in crypto-currencies has been over-stated. There have been a significant number of crypto-currency prosecutions in relation to money laundering and other crimes, illustrating that there is no guarantee of anonymity.

While crypto-currencies are growing in popularity, they currently facilitate a very small proportion of transactions. Because crypto-currencies intermediate such a small proportion of transactions, central banks do not presently view crypto-currencies as a material threat.Since crypto-currencies are not well-adapted to the provision of borrowing and lending, we also foresee an enduring role for traditional financial intermediaries.

Crypto-currencies and blockchain technology could well become an important part of global payment systems, but wide-scale adoption will depend on competition from alternative transaction technologies, and on regulation to provide users with security. Crypto-currencies will also need to address technical, scalability issues if they wish to intermediate the volume of transactions undertaken globally.

We conclude that all crypto-currencies are experimental in nature and users face material risks by transacting with them or by holding significant crypto-currency balances. Individual cryptoReserve Bank of New Zealand currencies may be more Betamax than VHS, and more MySpace than Facebook. Even if some of the constructs are enduring, such as distributed ledgers and the use of cryptography, specific crypto-currencies may be supplanted by competing transaction technologies. We close with a Latin expression much-beloved by contract lawyers and economists alike – caveat emptor – buyer beware.

The Analytical Note series encompasses a range of types of background papers prepared by Reserve Bank staff. Unless otherwise stated, views expressed are those of the authors, and do not necessarily represent the views of the Reserve Bank

Westpac capital requirements increased after breaching regulatory obligations

The Reserve Bank in New Zealand says that Westpac New Zealand Limited (Westpac) has had its minimum regulatory capital requirements increased after it failed to comply with regulatory obligations relating to its status as an internal models bank.

Internal models banks are accredited by the Reserve Bank to use approved risk models to calculate how much regulatory capital they need to hold. Westpac used a number of models that had not been approved by the Reserve Bank, and materially failed to meet requirements around model governance, processes and documentation.

“This is very disappointing. Operating as an internal models bank is a privilege that requires high standards and comes with considerable responsibilities. Westpac has not met our expectations in this regard,” Reserve Bank Deputy Governor and Head of Financial Stability Geoff Bascand said.

The Reserve Bank required Westpac to commission an independent report into its compliance with internal models regulatory requirements. The report found that Westpac:

  • currently operates 17 (out of 35) unapproved capital models;
  • has used 21 (out of 32) additional unapproved capital models since it was accredited as an internal models bank in 2008; and
  • failed to put in place the systems and controls an internal models bank is required to have under its conditions of registration.

The Reserve Bank has decided that Westpac’s conditions of registration should be amended to increase its minimum capital levels until the shortcomings and non-compliance identified in the independent report have been remedied.  Westpac’s minimum capital ratio requirements will be 6.5 percent for Common Equity Tier 1 capital, 8 percent for Tier 1 capital and 10 percent for Total capital, with the additional 2.5 percent capital conservation buffer applying.  Currently, for all other locally incorporated banks capital ratios are set at, respectively, 4.5 percent, 6 percent and 8 percent, plus the 2.5 percent buffer.

In addition, the Reserve Bank has accepted an undertaking by Westpac to maintain its total capital ratio above 15.1 percent until all existing issues have been resolved.  The Reserve Bank has given Westpac 18 months to satisfy the Reserve Bank that it has sufficiently addressed those issues or it risks losing accreditation to operate as an internal models bank.

“We believe the regulatory action is appropriate given the seriousness of Westpac’s non-compliance and the need to protect the integrity of the capital regime,” Mr Bascand said.

The Reserve Bank has taken into account that Westpac has not deliberately sought to reduce its regulatory capital. While there have been serious shortcomings and  non-compliance, it appears that Westpac has remained well above its required regulatory capital levels.

Westpac has confirmed that it does not dispute the findings of the independent report, that it is committed to remedying all the issues identified, and that it will maintain its total capital ratio above 15.1 percent.

RBNZ Holds Cash Rate At 1.75%

The New Zealand Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent. They are projecting higher rates ahead.

Global economic growth continues to improve, although inflation and wage outcomes remain subdued.  Commodity prices are relatively stable.  Bond yields and credit spreads remain low and equity prices are near record levels.  Monetary policy remains easy in the advanced economies but is gradually becoming less stimulatory.

The exchange rate has eased since the August Statement and, if sustained, will increase tradables inflation and promote more balanced growth.

GDP in the June quarter grew broadly in line with expectations, following relative weakness in the previous two quarters.  Employment growth has been strong and GDP growth is projected to strengthen, with a weaker outlook for housing and construction offset by accommodative monetary policy, the continued high terms of trade, and increased fiscal stimulus.

The Bank has incorporated preliminary estimates of the impact of new government policies in four areas: new government spending; the KiwiBuild programme; tighter visa requirements; and increases in the minimum wage. The impact of these policies remains very uncertain.

House price inflation has moderated due to loan-to-value ratio restrictions, affordability constraints, reduced foreign demand, and a tightening in credit conditions.  Low house price inflation is expected to continue, reinforced by new government policies on housing.

Annual CPI inflation was 1.9 percent in September although underlying inflation remains subdued.  Non-tradables inflation is moderate but expected to increase gradually as capacity pressures increase.  Tradables inflation has increased due to the lower New Zealand dollar and higher oil prices, but is expected to soften in line with projected low global inflation.  Overall, CPI inflation is projected to remain near the midpoint of the target range and longer-term inflation expectations are well anchored at 2 percent.

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

Banks Need To Grow Deposits In Line With Credit

The Reserve Bank New Zealand has published an Analytics Note entitled “Diving in the deep end of domestic deposits“.   They conclude that banks may need to limit credit growth unless they are able to grow retail deposits in line with credit growth.

Deposits are an important part of the New Zealand financial system. Deposits play a large role in funding bank lending – banks try to attract deposits in order to build up funds to lend out to borrowers. Over the past couple of years, lending has been growing faster than deposits, requiring banks to source funding from offshore wholesale funding markets. External funding can increase risks in the financial sector, as deposits are typically a more stable (“core”) source of funding than offshore wholesale funding.

This paper explores deposit growth in New Zealand in order to answer two questions:

1) What factors drive deposit growth in New Zealand, particularly in the past few years?

2) Can banks increase deposits by increasing interest rates?

We use two models to explore the dynamics of household deposits in New Zealand’s banking system in order to answer these questions. The first model uses bank-specific data from New Zealand’s four largest banks, while the second uses aggregate data for the entire banking system.

The paper highlights that the rate of domestic deposit growth has varied significantly since the Global Financial Crisis, and sharply slowed over 2016. We provide evidence that a range of supply and demand factors influence deposit growth, and that the recent slowing was largely driven by a reduction in supply (that is, households wanting to allocate less money to deposit products). We also find that banks increased their demand for deposits in late 2016 in an effort to close the gap between deposit growth and lending.

We also consider the degree to which banks are able to increase deposit growth materially by raising interest rates. We find that a 1 percentage point increase in the six-month deposit rate can increase the level of household deposits by about 1 percent after four quarters, and by 1.3 percent in the long-run.

As we find that deposits are not strongly responsive to interest rates, if banks wish to maintain robust funding profiles by not becoming too reliant on offshore wholesale funding, they may need moderate credit growth or use a combination of approaches to bring deposit growth in line with credit growth.

The Analytical Note series encompasses a range of types of background papers prepared by Reserve Bank staff. Unless otherwise stated, views expressed are those of the authors, and do not necessarily represent the views of the Reserve Bank.

Does past inflation predict the future?

Interesting Analytical Note from the Reserve Bank New Zealand. They have recently changed their modelling of inflation, preferring to use past data rather than a two year prediction because despite low unemployment, inflation has remained lower than would be expected on the old method. This suggests monetary policy needs to be more stimulatory than expected .

Forecasts of non-tradables inflation have been produced using Phillips curves, where capacity pressure and inflation expectations have been the key drivers. The Bank had previously used the survey of 2-year ahead inflation expectations in its Phillips curve. However, from 2014 non-tradables inflation was weaker than the survey and estimates of capacity pressure suggested. Bank research indicated the weakness in non-tradables inflation may have been linked to low past inflation and its impact on pricing behaviour.

This note evaluates whether measures of past inflation could have been used to produce forecasts of inflation that would have been more accurate than using surveys of inflation expectations. It does this by comparing forecasts for annual non-tradables inflation one year ahead. Forecasts are produced using Phillips curves that incorporate measures of past inflation or surveys of inflation expectations, and other information available at the time of each Monetary Policy Statement (MPS). This empirical test aims to determine the approach that captures pricing behaviour best, highlighting which may be best for forecasting going forward.

The results show that forecasts constructed using measures of past inflation have been more accurate than using survey measures of inflation expectations, including the 2-year ahead survey measure previously used by the Bank. In addition, forecasts constructed using measures of past inflation would have been significantly more accurate than the Bank’s MPS forecasts since 2009, and only slightly worse than these forecasts before the global financial crisis (GFC). The consistency of forecasts using past-inflation measures reduces the concern that this approach is only accurate when inflation is low, and suggests it may be a reasonable approach to forecasting non-tradables inflation generally.

From late 2015, the Bank has assumed that past inflation has affected domestic price-setting behaviour more than previously. As a result, monetary policy has needed to be more stimulatory than would otherwise be the case. This price-setting behaviour is assumed to persist, and is consistent with subdued non-tradables inflation and low nominal wage inflation in 2017.

Figure 6 shows the average 1-year ahead forecast of non-tradables inflation for the measures of past inflation and surveys of inflation expectations. The range of forecasts produced by the models is currently large relative to history, perhaps reflecting differences between the surveys of inflation expectations and measures of past inflation. The two most accurate measures (shown by the red lines) suggest non-tradables inflation will be between 2.5 and 3 percent in 2018 – similar to the forecast in the August 2017 MPS and only a little higher than the latest outturn of 2.4 percent in the June quarter 2017.


Non-tradable inflation has been surprisingly weak since 2014. Phillips curves with the survey of 2-year ahead inflation expectations suggest non-tradables inflation should have risen by more than we have seen, given the level of the unemployment rate and the Bank’s estimates of the output gap. This note shows that using measures of past CPI inflation instead of surveyed inflation expectations would have produced more accurate forecasts of non-tradables inflation, although not all of the weakness in non-tradables inflation would have been predicted.

The Bank has adjusted its forecasting models to better capture the role of past inflation, moving away from using the survey of 2-year ahead inflation expectations to underpin its forecasts

The Analytical Note series encompasses a range of types of background papers prepared by Reserve Bank staff. Unless otherwise stated, views expressed are those of the authors, and do not necessarily represent the views of the Reserve Bank.

NZ Holds Official Cash Rate 1.75 percent

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

Global economic growth has continued to improve in recent quarters. However, inflation and wage outcomes remain subdued across the advanced economies and challenges remain with on-going surplus capacity. Bond yields are low, credit spreads have narrowed and equity prices are near record levels.  Monetary policy is expected to remain stimulatory in the advanced economies, but less so going forward.

The trade-weighted exchange rate has eased slightly since the August Statement.  A lower New Zealand dollar would help to increase tradables inflation and deliver more balanced growth.

GDP in the June quarter grew in line with expectations, following relative weakness in the previous two quarters.  While exports recovered, construction was weaker than expected.  Growth is projected to maintain its current pace going forward, supported by accommodative monetary policy, population growth, elevated terms of trade, and fiscal stimulus.

House price inflation continues to moderate due to loan-to-value ratio restrictions, affordability constraints, and a tightening in credit conditions. This moderation is expected to continue, although there remains a risk of resurgence in prices given population growth and resource constraints in the construction sector.

Annual CPI inflation eased in the June quarter, but remains within the target range. Headline inflation is likely to decline in coming quarters, reflecting volatility in tradables inflation.  Non-tradables inflation remains moderate but is expected to increase gradually as capacity pressure increases, bringing headline inflation to the midpoint of the target range over the medium term.  Longer-term inflation expectations remain well anchored at around two percent.

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