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MAR 14

Currency Intervention

Last week we saw the first move by the Reserve Bank of New Zealand (RBNZ) to tighten its monetary policy by raising the Official Cash Rate (OCR) 25 basis points to 2.75%. Soon after we saw the New Zealand dollar reach a post-float high on the Trade Weighted Index (TWI), breaking the 80 mark.

Following the increase of the OCR, Deputy Governor of the RBNZ Grant Spencer explained the Banks thoughts and reasoning around the current level of the New Zealand dollar. Firstly, they made the point that the New Zealand dollar is unsustainably and extremely high, but they are not considering intervention. This is shedding “crocodile tears” for the tradable sector, acknowledging the huge headwind the currency is having, but unwilling to make any policy response.

He also explained their “traffic light” system around currency intervention. This requires the level of the currency to be extreme, unsustainable and that the intervention is consistent with current monetary policy. Currently, the reasoning for not intervening in the currency, despite its extremely high levels, is due to the very liquid market and the fact such intervention would clash with their monetary policy tightening to tackle inflationary pressure. It does not have to be that way but giving up is always an option.

The decision to ignore our overvalued currency is driven by the simplicity of the Policy Target Agreement (PTA), which aims to keep inflation within a 1% to 3% target band over the medium term. One way to do this in the medium term is to deflate, via the currency mechanism, the traded sector – more discussion here on that matter. In the long term, this approach attacks the profitability and return on investment of the traded sector to the point that firms fail or relocate offshore.

Does an overvalued currency help keep consumer prices down? While this is true to some extent, the magnitude of the exchange rates pass through to consumer prices is less than many may think. A paper by the Reserve Bank of Australia (RBA) estimated that a 10% exchange rate appreciation typically results in a 1% reduction in overall consumer prices, spread over around three years.

While the pass though of the exchange rate to consumer prices is relatively low, the high dollar inflicts immediate and long term effects on exporters and import competing manufacturers. This has an immediate effect on margins, and has long term ramifications. If a firms margin is eroded by the currency, investment decisions will reflect this. Without investment, future competitiveness, innovation and employment will be constrained. None of these outcomes are good for New Zealand in the long run.

Monetary policy has not restrained inflation at its source, the non-traded economy; we have been sold the myth of price stability at the cost of a deflated tradable sector. Medium term success will turn out to be a long term failure as the tradable sector shrinks in capacity and capability.

This has been our world for some time now, if nothing changes expect more of the same, ever reducing margins in the tradable sector. Ask yourself; is it harder or easier to make a buck today than a decade ago? Then ask why?

As the link to the Swiss National Bank policy document demonstrates, inflation can be controlled without deflating the tradable sector, broader policies can do this. It is a matter of choice; medium or long term success.

tags: trade, tradable, exports, swiss, currency, exchange rate, monetary policy, ocr, grant spencer
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