Reserve Bank will use new rules to battle inflation

BUSINESSDESK: New rules to curb credit booms will be used to control interest rates and the exchange rate along with existing monetary policy tools, Reserve Bank assistant governor Grant Spencer says.

Mr Spencer, a front-runner to replace retiring governor Alan Bollard this August, used a speech to a remuneration forum in Auckland to outline how macro-prudential requirements introduced after the global financial crisis were likely to become another tool in the armoury for fighting inflation.

His comments come as the Labour and Green parties seek to pressure the government over the high New Zealand dollar with claims a greater range of measures and more flexible benchmarks are required for the conduct of monetary policy.

Mr Spencer focused especially on the so-called counter-cyclical credit buffer, "an additional capital requirement that local supervisors may apply when credit is booming, and remove when the cycle is turning down".

"Such policies will tend to have the effect of either dampening the credit cycle or dampening international capital flows and hence exchange rate pressures," he said.

"For those reasons, macro-prudential policies might be expected to play a useful secondary role in helping to stabilise the macro-economy.

"Because of the potential assistance from macro-prudential policy, there may well be situations where monetary policy seeks the support of macro-prudential policy, just as it may seek the support of fiscal policy," he said.

However, such measures could only be used to assist monetary policy where it was consistent with the primary objective of financial system stability.

Mr Spencer, who has been responsible for financial stability throughout the global financial crisis, warned that lead times for banks to implement changes in their capital ratios meant it could be six to 12 months before the impact of such buffers began to bite.

"These policy settings are less amenable to fine tuning," he said.

"In that sense, macro-prudential policy is likely to be taken as a background 'given' when it comes to making short-term monetary policy decisions."

In other words, it could not "replace" monetary policy and would "never be as powerful or as flexible an instrument as the official cash rate".

Mr Spencer also announced the RBNZ would now require New Zealand-registered banks to up their core funding ratio - a measure of their most stable assets - from 70% of loans and advances to 75% from January 1 next year.

The increased ratio was to have come into effect next month, but was deferred because of difficult international market conditions late last year.

He also confirmed the bank remains committed to formalising its existing powers to close a failing bank temporarily and impose a financial "hair-cut" across its investors and depositors, to allow a swift reopening, which would hopefully prevent a bank run while sheltering taxpayers from the cost of a government bailout.

New Zealand is almost alone in pursuing this "open bank resolution" policy, which will not apply in Australia, where most of New Zealand's largest banks are owned.

"OBR gives the government a realistic alternative to the costly bailout option should a large bank get into difficulties," Mr Spencer said.

"The policy also serves as a reminder that there are no guaranteed institutions, thus helping to limit moral hazard in the financial system."

Under the central bank’s policy targets agreement, it aims to keep inflation between 1% and 3% over the medium term.