Ups and Downs: Is the Reserve Bank Managing to Control the Exchange Rate?

Listener 20 September, 1997.

Keywords: Macroeconomics & Money;

When a decade ago this columnist talked about the Reserve Bank of New Zealand (RBNZ) “quasi-targeting” on the exchange rate, the conventional wisdom said that this was a nonsense. Over the years that quasi-targeting became increasingly explicit, as illustrated by the RBNZ’s Monetary Conditions Index. The MCI, as it is known, combines a short term interest rate and the exchange rate (measured by a trade weighted index – the TWI), to give a quantitative indicator of the RBNZ’s assessment of monetary conditions. The RBNZ even sets a range in which the MCI should hover. As I write the index is meant to be between 775 and 875, although it is likely to be changed with the new monetary policy announcement by the RBNZ, this Thursday (18th).

But whatever the RBNZ proposes, the market may ignore. At the time this column was filed the MCI was around 50 points below the set range. It has been under it ever since it was announced at the time of the June budget. This means that officially monetary conditions are looser than the RBNZ wants. Practically it means that the short term interest rate and the exchange rate are lower that what the RBNZ envisaged. It is true that short term interest rates rose about a month ago, and mortgage interest rates followed them up. but the exchange rate continued to fall. If the current exchange rate level persists, the only way the MCI could get back into the target range would be for interest rates to rise even more – upsetting borrowers even further.

In fact the exchange rate and interest rates are behaving in an unusual way. Normally a rise in interest rates increases the exchange rate, as foreign investors are attracted into high interest New Zealand bonds. But the exchange rate has kept drifting down. If this goes on for too long we are in what economists call a “balance of payments crisis”, although “crisis” may be too strong a word. The column has previously discussed the possibility, so as not to be too repetitive, I summarize. The current account deficit, that is the excess of imports of goods and services and debt servicing over exports, is now near 5 percent of GDP. In the past this level was a trigger for the government to take action. However the rules are a little different under a floating exchange rate regime. Nowadays the need is to get foreign investors to cover the deficit by lending to New Zealand. They will do so as long as they have confidence they will get a high return on their lending. Hence our high interest rates. But this return can be wiped out by a depreciation (fall) in the exchange rate. When that begins, shrewd investors start withdrawing their lending, not too precipitately, and we observe the exchange rate sinking, despite hikes in interest rates. That is probably what has been happening.

How long this will go on? My view is that underlying conditions – the economic fundamentals – are poor, with a large current account deficit while the economy is near stagnant. Until we get the economy in a better shape, with more profitability and growth in the tradeable sector, the exchange rate will continue to sink (or, in the jargon, have a “downside risk”), despite high domestic interest rates. However advocates of the reforms are convinced the fundamentals are right, while financial economists whose livelihood depends on telling overseas investors that everything is hunky dory, tell the media too.

How will the government respond? It could intensify existing policies to give foreign investors confidence. But even if it does, it only puts off the day of reckoning, unless the fundamentals really are right. What do we expect the RBNZ to do? Keep ramping up interest rates as a brake on the falling dollar?

As far as exhortation is concerned (telling us what should happen, in a bullying way reminiscent of Rob Muldoon), the RBNZ Governor seems to have exhausted his credibility. There are also technical actions, like reducing bankers’ cash to below $5m, which however could signal there was a crisis on. The RBNZ no longer sells foreign exchange to sustain a particular exchange rate (or MCI, in the current policy regime). Direct controls have been ruled out. There is not a lot left to do except let the exchange rate sink, beating a retreat by lowering the MCI target range (which might be justified by the slackness of the economy).

But a lower exchange rate and higher interest rates feed through into higher prices. Already we can expect consumer inflation to move once again outside the target range of less than 3 percent p.a. for a while.

Such things should not be happening if the fundamentals were right. The greatest danger is when enough of the financial economists come to this realization and panic, when the soothers and soothsayers suddenly find they have been desperately wrong. Their hysteria is likely to alarm the nation at a time when the economy needs sobriety and careful analysis.