for the first time for many years the central banks of the big developed countries were faced with a prospect of deflation and capital inflows. they reacted strongly by cutting interest rates radically. the us federal reserve, for example, slashed rates from 6. 5 per cent ( the new zealand rate ) in 2001 to only 1 per cent in 2003. ( in new zealand we were much more cautious, only cutting rates to 5 per cent. ) " new zealand has never in recent years had to run monetary policy in an environment where the g - 3 economies - the us, japan and europe - were running such loose monetary policy of their own. " the problem was exacerbated because the new zealand business cycle was running well ahead of those in the big economies : while they were still worried about deflation, we could see inflation pressures mounting. demand was very strong in many domestic industries, capacity utilisation was reaching record high levels and skill shortages were becoming acute. " new zealand started raising rates in january 2004, just ahead of the us federal reserve's long climb back towards neutral real rates. initially as we put up the official cash rate, new zealand shortterm market rates rose as expected, but the long end remained stubbornly low, anchored to us rates expectations. " we were experiencing another outcome of financial globalisation : long - term rates in new zealand have over the last decade started to become very closely correlated with us long rates. " in new zealand the floating mortgage rate rose quickly. households increasingly switched to cheaper fixed - rate mortgages. the banks could readily provide these due to the cheap new zealand dollar funding offered by overseas investors through instruments such as uridashis and eurokiwis. in 2003, less than 60 per cent of all mortgages were fixed, by 2006 it was more than 80 per cent. competition between the mortgage lenders also acted to keep fixed rates low as bank margins were reduced to historically low levels. " the reserve bank kept pushing up the official cash rate to slow demand. the effective mortgage rate, the main transmission mechanism for monetary policy in new zealand, rose, but to only half the extent of the official cash rate increase. monetary policy was working, but more slowly than the reserve bank would have liked. " we could see that the full effects would eventually flow through on to mortgages, but in the meantime homeowners seemed to be borrowing on the expectation that rates would stay low. in doing so, households were sk

banks reported that they would need to cut credit exposures by around 10 percent ( the equivalent of around $ 30 billion ) in order to restore capital buffers. deleveraging of that nature would accentuate macroeconomic weakness, leading to greater declines in asset markets and larger loan losses for the banks. such second round effects are not reflected in the stress test results. a key goal of macro - prudential policy is to ensure that the banking system has sufficient resilience to avoid such contractionary behaviour in a downturn. the macro - prudential policy approach we have adopted has been centred on loan to value ratios ( lvrs ). in october 2013, the bank introduced a requirement that no more than 10 percent of any bank ’ s new mortgage lending could be at lvrs over 80 percent. at the time, over 30 percent of new mortgages were being written at lvrs over 80 percent. restricting the extent of high lvr lending has seen average lvrs in bank mortgage books gradually decline, with the proportion of high lvr mortgage loans on bank balance sheets falling from 21 percent to 14 percent. this has made bank balance sheets more resilient to a potential housing downturn ( figure 7 ). at the same time, the reduction in high lvr lending helped to dampen credit growth and house price inflation over the following year. subsequently, from around september 2014, the auckland market started to accelerate while house prices in the rest of the country continued to moderate. as mentioned earlier, we have identified credit - financed investor activity as an important contributor to the auckland resurgence. this raises concerns from a systemic risk perspective. evidence from severe housing market downturns internationally show that loans to investors default more frequently at any given lvr during periods of market stress. partly this is likely to reflect the fact that investors tend to take on more debt relative to income, so have less ability to absorb income shocks. the reserve bank has recently started collecting data on the debt to income ( dti ) ratios of new borrowers ( figure 8 ). provisional data suggests that a much greater share of investors have high dtis and that investor dtis have been growing over the past year. international evidence also suggests that investors play a strong role in amplifying property cycles. investor participation tends to rise towards the peak of the property cycle and investors are more likely to sell properties when prices start to fall. thus, property cycles are accentuated when there is a large investor presence