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Understanding the New Zealand exchange rate

Addressing underlying imbalances in the New Zealand economy is the key to addressing New Zealand?s overvalued exchange rate, Reserve Bank Assistant Governor and Head of Economics Dr John McDermott said today.

Addressing underlying imbalances in the New Zealand economy is the key to addressing New Zealand's overvalued exchange rate, Reserve Bank Assistant Governor and Head of Economics Dr John McDermott said today.

In a speech to Federated Farmers Meat and Fibre Council in Wellington, Dr McDermott said that policies to encourage private sector savings, and to increase flexibility in the economy are the way to sustainably lower New Zealand's real interest rates and take pressure off the exchange rate.

"The nominal exchange rate is currently at historically high levels against nearly all of our trading partners. The real exchange rate – which takes into account relative inflation rates and so is a better measure of overall competitiveness – is also at historically high levels."

Dr McDermott said that much of the New Zealand dollar's current strength can be explained by factors such as New Zealand's current high terms of trade, especially dairy prices, and relatively strong economic performance.

"However, the Reserve Bank believes that, from a long-term perspective, the exchange rate is overvalued. The high exchange rate is contributing to economic imbalances and the Reserve Bank would like to see it lower in order to promote more sustainable economic growth.

"Whether the exchange rate is overvalued from a long-term perspective relates to the effects it has on real economic outcomes. For instance, an overvalued exchange rate will affect the tradable sector's profitability and its decisions about investment, employment, and market strategy."

Dr McDermott said that commentators have provided a range of suggestions to correct the overvaluation problem, including: keeping interest rates low; currency intervention; quantitative easing; capping the exchange rate; and changing the focus of monetary policy to target the exchange rate.

"Many of these suggestions are unlikely to have a significant lasting effect on competitiveness, or would have unpalatable trade-offs such as much higher inflation, or are simply not feasible," he said."

Evidence in New Zealand and elsewhere suggests foreign currency intervention is unlikely to have a sustained impact in lowering the exchange rate.

"Saying there is little monetary policy can do about the exchange rate, however, is not the same as saying there is little that can be done."

Dr McDermott said that a lack of flexibility in other parts of the economy means that the exchange rate can overshoot where it should be in the long run.

"For instance, microeconomic policies can promote greater competition and remove roadblocks to the reallocation of resources in response to market signals. Such policies would reduce the need for the exchange rate to carry the burden of absorbing economic shocks. An example here could be increasing the responsiveness of the building industry to housing demand.

"Likewise, reducing the magnitude of domestic demand cycles would reduce the pressures that monetary policy needs to lean against. This includes avoiding pro-cyclical changes in fiscal policy such as tax cuts or increasing public spending when resources are already stretched, or deterring banks from excessively relaxing credit standards when demand for financing is strong. Such actions will ease cyclical exchange rate pressures."

However, for a sustained reduction in the exchange rate, it is necessary to alter the level and pattern of saving and investment, in particular New Zealand's reliance on foreign savings to finance our consumption and investment, Dr McDermott said.

Media Contact:
Mike Hannah, Head of Communications
Ph 04 471 3671, 021 497 418, [email protected]