ENDORSEMENT
Transmission of
monetary policy to
financial conditions
By Karen Silk, Assistant Governor/General Manager
Economics, Financial Markets and Banking
A speech delivered to the Citi Australia & New Zealand Investment Conference in
Sydney, Australia on Wednesday 16 October1
With thanks to Chris Stephens for his help in preparing these remarks
Introduction:
E ngā mana, e ngā reo. E ngā karanga maha o te wā.
Tēnā koutou, tēnā koutou, tēnā koutou katoa.
Good morning. I would like to start by thanking Citi for hosting today's event and inviting me to
speak. As a member of the Monetary Policy Committee, with my colleagues, I spend a fair amount
of time considering the effectiveness of monetary policy transmission through wholesale markets
and banking channels as we seek to influence economic outcomes and inflation. It is this area that
I'm going to address today.
The transmission of policy rate changes to inflation is a gradual process. It's surrounded by
uncertainty and impacted by the prevailing economic and financial conditions. It requires ongoing
monitoring, and the Monetary Policy Committee (MPC) meets regularly to assess the extent to,
and speed at, which the current stance is influencing the financial system and the economy.
Should data indicate that conditions are evolving differently to those expected, or if we judge that
the balance of risks to the inflation outlook have changed, then we are able to adjust our
approach to reflect this.
Today I will discuss:
 our assessment of the level of restrictiveness of monetary policy settings through the
postCOVID period,

factors that have influenced the transmission to tighter financial conditions, and
 how these may influence the transmission to financial conditions in the period ahead.
What does it mean for the policy rate to be restrictive and how do we know
when it is?
Monetary policy settings are a key determinant of financial conditions.1 These financial conditions
include the interest rates at which households and businesses save and borrow, the level of the
exchange rate and credit availability. To drive inflation lower over recent years, it has been
necessary for us to tighten policy settings, which have in turn restricted overall financial
conditions.2 This has contributed to a weakening of aggregate demand in the economy and
increased our confidence that consumer price inflation (CPI) is moving sustainably back to its
target mid-point of 2 percent.
There are a range of ways in which we assess the restrictiveness of our monetary policy stance.
One way is to compare the level of the Official Cash Rate (OCR) with our estimates of the nominal
neutral OCR. This is a useful concept to help us understand whether our current stance is
encouraging or acting as a brake on economic activity, or holding it steady.3 However, its inherent
uncertainty means that at any point in time we can't pinpoint the neutral level with complete
accuracy4. To help manage this uncertainty, the RBNZ maintains a suite of neutral OCR estimates,
based on different models and assumptions.5 Our neutral OCR measures, shown in this chart,
indicate that monetary policy is currently restrictive and has been for an extended period of time.
Figure 1: OCR versus nominal neutral OCR estimates
Source: RBNZ estimates.
Note: The shaded area indicates the range between the minimum and maximum values from our suite of long-run nominal neutral
OCR indicators.
We also keep a close eye on a range of indicators of domestic financial conditions. These
indicators help us gauge how our monetary policy stance is impacting broader financial conditions
faced by households and businesses, and in turn how they may be influencing spending,
investment, and borrowing decisions across the economy.
Figure 2: Financial conditions overview
Source: RBNZ, Bloomberg, Interest.co.nz, Stats NZ.
Note: All data is shown as of the 4 October 2024, apart from the mortgage interest as a % of household disposable income, which is
quarterly (latest quarter is Q2 2024) and yield on business loans, which is monthly (latest month is August).
This chart, which includes some of the indicators that we look at, provides a snapshot of current
financial conditions in New Zealand and indicates how they have moved since the start of the year.
The scale on the chart reflects the historical distribution of each measure since 2009, moving from
very loose on the left to very tight on the right. The pink dot shows the current value, while the
blue dot shows the values at the start of the year.
These indicators paint a similar picture to our neutral interest rate estimates. Wholesale, bank
lending, and bank deposit rates all remain broadly restrictive. This is despite some loosening over
2024 as markets anticipated the start of the easing cycle. Home loan interest costs as a proportion
of disposable income have risen to their highest level since 2010 but remain lower than the period
following the Global Financial Crisis (GFC). Conversely, bank credit has remained more
accommodative, in line with strong bank funding positions.
The downstream effects on the domestic economy also indicate the stance has been restrictive.
High interest rates are reducing demand in New Zealand. Weak household consumption and
business investment, easier labour market conditions and lower wage growth, along with declining
inflation expectations, are providing reassurance that our monetary policy stance has been
sufficiently restrictive to support CPI to fall back to our target mid-point.
Monetary policy transmission to financial conditions during the recent
tightening cycle
Transmission from a change in the OCR to domestic financial conditions occurs in two stages.6
During the first stage, policy rate changes and expectations for future interest rates influence the
level and direction of wholesale interest rates.
Figure 3: OCR and New Zealand wholesale rates
Source: RBNZ, Bloomberg
Short-term rates are more heavily influenced and responsive to the level of, and near-term
expectations for, the OCR, while longer-term rates can be significantly influenced by broader
factors like inflation expectations and global investor risk sentiment. As a result, the magnitude and
pace of influence on long-term rates can vary significantly7.
For example, market expectations for higher global inflation during 2021 contributed to higher
long-term global interest rates8. We can see in this chart that this led the New Zealand 10-year
swap rate to increase earlier than short-term wholesale rates and the OCR.
The second stage is the transmission from wholesale rates to bank lending and deposit rates.
During a tightening cycle, banks face higher funding costs which they pass through to higher
lending rates. Higher debt servicing costs reduce free cashflow and in turn limit the ability of
households and businesses to consume and invest. Higher interest rates also increase incentives
for saving, reduce incentives for investing, and impact household wealth through lower asset
prices, which further influence spending behaviour.
This occurs gradually, and its effectiveness in New Zealand and Australia is often shaped by an
interplay between structural and cyclical factors impacting banks.
Structural and cyclical factors influencing monetary policy transmission to
financial conditions
Two important structural factors are the level of outstanding household debt and the importance
of the banking system as a provider of debt capital. In countries with higher levels of household
debt, all else equal, tighter monetary policy more effectively reduces free cash flow. This feeds
through to lower consumption and investment, compared to countries with lower levels of
household debt.9
If a large proportion of debt capital is provided via the banking system, policy rate changes directly
affect the borrowing costs for a significant portion of households, as banks adjust mortgage rates
accordingly.
Figure 4: Household debt as a proportion of GDP
This chart shows that household debt as a proportion of Gross Domestic Product (GDP) is higher
in New Zealand and Australia than in the United States and euro area. As banks are the primary
source of lending to households in our two countries, transmission through the banking channel
will also play a prominent role.
A second key factor is the interest rate structure of household debt. There is a notable difference
between Australia and New Zealand in this regard. In New Zealand, the majority of home lending
carries a fixed interest rate, with historically terms of 1 or 2 years being most popular. In contrast,
most Australian home loans are referenced to a floating interest rate. This means that typically it
takes slightly longer for changes in the monetary policy stance to pass-through to the average
outstanding home loan rate in New Zealand relative to Australia.
This chart shows the impact of this variance over the recent tightening cycle. The Reserve Bank of
Australia (RBA) raised its policy rate for the first time in May 2022, seven months after the RBNZ.
Despite this, Australia experienced a larger increase in its average outstanding home loan rate in
2022 compared to New Zealand. This highlights the difference in the pace of monetary policy
transmission to housing loan rates, but not the overall increase in the OCR, which was greater in
New Zealand.
Transmission via this channel for both New Zealand and Australia occurs faster than for many
other economies. For example, in the US and some European countries, where 25- or 30-year
fixed rate mortgages are fairly common10. Despite this, monetary policy is still effective in these
countries, with other transmission channels playing a more important role11.
Figure 5: Average outstanding mortgage rates in New Zealand and Australia
Source: RBA and RBNZ
While the effectiveness of various monetary policy transmission channels can differ across
countries for structural reasons, these can also differ within countries but across business cycles
depending on the prevailing economic and financial environment.
An example of a cyclical factor is the ongoing influence of the COVID-era fiscal expansion and
monetary policy easing. A combination of fiscal policy measures such as the COVID-19 Wage
Subsidy and the implementation of additional monetary policy tools in New Zealand, led to a
significant increase in liquidity within the financial system contributing to strong deposit growth in
commercial banks and an abundance of liquid assets.
In turn this bolstered banks' stability with prudential liquidity measures12 rising well above their
minimum requirements.
Alongside this, the composition of bank deposits changed significantly with deposit volumes
shifting from more traditionally expensive term to cheaper on-call deposits, in part driven by a
narrowing in the difference in rates as supply increased13. This chart shows how the proportion of
savings held in term deposits, in blue, quickly declined during the COVID period, as the rate
premium for holding term deposits relative to on-call savings accounts fell.
Figure 6: Saving deposit rates and the term deposit share of total saving deposits
Source: RBNZ Bank Balance Sheet survey, RBNZ estimates
Deposits account for around 65 percent of total bank funding in New Zealand and so the change
in composition and overall increase in supply contributed to a significant decline in bank funding
costs through that period.
As wholesale rates began to increase from mid-2021 in line with more restrictive monetary policy,
banks were however able to maintain lower term and on-call deposit rates for longer largely as a
consequence of the higher COVID-period level of savings, higher levels of liquidity, and weakening
credit demand. Further, and despite the re-emergence of a premium on term deposits over
oncall deposits through 2022, reversion to the pre-COVID composition of term deposits is yet to fully
occur.
Despite deposit rates increasing slower than usual in this cycle, the increase in average outstanding
deposit costs has been greater in New Zealand and Australia than in many other peer economies
after accounting for the degree of monetary policy tightening.14 This is largely due to differences in
the interest rate structure of bank balance sheets. Assets and liabilities in New Zealand and
Australia tend to be shorter in nature and therefore changes to interest rates more quickly flow
through to average interest costs and revenues.
Figure 7: Weighted average bank funding costs in New Zealand (spread to BKBM)
Source: RBNZ estimates, Bloomberg
This chart shows our estimate of weighted bank funding costs compared to the 90-day Bank Bill
Benchmark Rate (BKBM)15, which is New Zealand's equivalent of your 90-day Bank Bill Swap Rate
(BBSR). It shows that the lower cost and higher volume of deposits has been a large drag on bank
funding costs since mid-2020.
Monetary policy transmission to lending rates
An on-going assessment of bank funding costs is important as they are a key influence on bank
lending rates. We can use a simplified home loan pricing model to understand the influence of
bank funding costs and other factors on the transmission of monetary policy. There are three
component parts to the model:
1. The level of wholesale rates e.g. the 2-year swap rate.
2. The size of funding spreads. The funding spread is our estimate of the relative cost of bank
funding and reflects the difference between the rates that banks pay for retail deposits and
wholesale funding versus wholesale rates.
3. A residual or mark-up. This is the difference between the home lending rate and the prior two
components. This broadly reflects banks' gross profit on home loans.
This simplified framework is a useful tool for identifying - in a big picture sense - which
component is driving home loan rate changes. It is valuable because the implications for monetary
policy can vary depending on how each component behaves. For example, traditionally there has
been a significant degree of pass-through from changes in wholesale rates into home loan
pricing,16 which is important for monetary policy transmission as wholesale rates are influenced by
future expectations for the OCR level. However, the effectiveness of this channel of monetary
policy transmission can also be influenced by changes in bank funding spreads and the residual or
mark-up component, both of which depend mostly on factors other than monetary policy rate
decisions.
Utilising this framework, the chart below shows how the 2-year mortgage rate and its component
parts have evolved since 2016. The wholesale component, in this case the 2-year swap rate, has
broadly tracked the path of the monetary policy rate, as we'd expect. The funding spread, however
experienced a major shift from mid-2020 as a result of the higher volume of low-cost deposits
within the bank funding mix. This shift has had meaningful implications for the pass-through of
policy rate changes to home loan rates.
Figure 8: Decomposition of the 2-year mortgage rate
Source: RBNZ estimates, Bloomberg
Through the tightening cycle, the trough-to-peak increase in the New Zealand 2-year swap rate
was 570 basis points. However, the lower cost of funding experienced through that period by
banks, as represented by the funding spread, meant that this increase was not fully
passedthrough to home loan rates, with a trough-to-peak increase in the 2-year mortgage rate of 450
basis points.
Our estimate of the average bank mark up on a 2-year mortgage through the same period
increased from around 2.0 to 2.8 percent. As home loans account for a large proportion of total
bank assets (currently around 50 percent on average), this contributed to an increase in the net
interest margin generated by banks through this period. As shown in the chart, from the first OCR
increase in October 2021 to the last one in May 2023, the biggest four banks in New Zealand, on
average, saw their net interest margins increase by about 35-40 basis points.
Figure 9: Bank net interest margins
Source: RBNZ Income Statement survey
The upshot of this is that financial conditions were less restrictive during the recent tightening cycle
for the same level of the OCR when compared with previous cycles. However, through ongoing
monitoring we have been able to identify and factor this into our decision-making to ensure that
financial conditions have been where we needed them to be to achieve our monetary policy
objectives. The OCR, and wholesale rates, have been slightly higher than they otherwise would
have been to account for this.
Monetary policy is working, and we have confidence that inflation is moving
back to its target level
I will finish today by talking briefly to how these factors may continue to influence the path ahead.
Over recent meetings the Committee has become increasingly confident that monetary policy has
had the desired effect, and that economic conditions are supporting the convergence of CPI back
to the target mid-point of 2 percent. However, the building blocks of transmission from lower
policy rates to domestic financial conditions may once again be slightly different than experienced
in previous easing cycles.
In the current low credit growth environment, home loan rates have responded to falling
wholesale rates as markets have pre-positioned future OCR cuts. Likewise, borrowers have been
fixing interest rates for shorter terms, which all else being equal, should reduce the time it takes for
lower interest rates to be reflected in household and business cashflows. Our latest New Credit
Flows survey shows that around 75 percent of new home loan flows currently carry interest periods
of 1-year or less and circa 70 percent of existing home loans will be repriced within the next 9
months.
Bank funding spreads, however, have gradually increased this year, and this is expected to
continue as excess liquidity is drained from the banking system with the progressive wind down of
additional monetary policy tools. Over time this is likely to influence the amount of the decline in
bank lending rates, even in the face of lower wholesale rates, as banks seek to maintain their net
interest margins. However, given bank funding spreads have already begun to normalise, this
offset will likely be much smaller than was the case during the tightening cycle, which will reduce
the need to factor this into OCR decisions to the same degree in the years ahead.
In summary:
Monetary policy has been sufficiently restrictive to ensure that broader financial conditions are
supporting the achievement of RBNZ inflation objectives
The monetary policy stance however is not the only influence on financial conditions. Ongoing
monitoring of structural and cyclical factors influencing its' transmission through financial channels
to the economy is required to ensure that the stance of monetary policy reflects these.
Reversion to pre-COVID funding conditions for banks is underway and, all else being equal, will
constrain how far lending rates will fall as banks seek to preserve their net interest margin.
Ultimately however, while factors discussed in this speech are important for understanding the
pace and magnitude of monetary policy transmission, there are clearly many others that are
considered in monetary policy decision-making. While we have increased confidence that CPI is
moving back towards our 2 percent target mid-point we are also conscious of the broader set of
economic conditions required to manage inflation back to target. We will continue to assess and
respond to risks, on both sides of the ledger.
Thank you.
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