Liquidity policy a macro lever

Prudential policy on banking may serve as a companion tool to monetary policy, the Reserve Bank of New Zealand suggested on Friday.

As the New Zealand economy enters the growth phase and the market speculates on the timing of the first hike in the official cash rate, the RBNZ governor, Alan Bollard, has hinted that rate increases may not keep up to the pace of growth in the economy.

A second policy tool - the new liquidity policy that applies to banks - may handle the rest of the work that would otherwise fall to the manipulation in the cash rate.

In a speech on Friday, Bollard said, "The core funding ratio could potentially act as an automatic stabiliser and reduce the required hikes in the OCR during economic upturns." Bollard was speaking at the Canterbury Employers' Chamber of Commerce.
 
The core funding ratio is the key element of the revised prudential liquidity policy of the RBNZ, which comes into force in April 2010.  

This policy requires banks to maintain their one-year core funding ratio at a minimum of 65 per cent. This level is expected to increase to 75 per cent in stages over time.

The ratio is aimed at ensuring that banks increase their reliance on longer-term and stable funding. In practice this effect means the overall cost of bank funding will most likely rise.
 
The RBNZ believes the core funding ratio could contribute to the monetary policy task by limiting banks' ability to fuel credit growth using cheap and plentiful short-term wholesale funding during boom periods, such as the one from 2003 to 2007.

In the December 2009 monetary policy statement, the RBNZ cited the wider gap between the OCR and bank funding costs as one of the reasons it was not taking any immediate action in terms of monetary policy, even as the economy continues to recover.
 
The RBNZ didn't echo the same view in its OCR statement last week, but Bollard now seems to be suggesting the OCR hike will depend on what impact the liquidity policy will have on banks' funding costs, and thus the overall rates in the economy.
 
The RBNZ is also attempting to gauge if the minimum capital requirement will assist in monetary policy too and at this stage believes there is little clarity on this. This is because large lenders in New Zealand hold capital in excess of the current regulatory requirement and therefore a minimum norm would not necessarily push up the pricing of its loans.
 
In conclusion, Bollard said on Friday, "At best, these instruments could supplement the role of the OCR, but will not fundamentally alter it."