Forces affecting the NZ economy and policy challenges
The Reserve Bank will need to draw on all its policy instruments to achieve its price and financial stability objectives in an environment of domestic and external pressures, Governor Graeme Wheeler said today.
"As a small open economy, New Zealand can expect to be buffeted by an array of shocks," Mr Wheeler said in a speech to the Auckland Institute of Directors. "But these are extraordinary times.
"Not only does the economy need to absorb the impact of a significant drought and the resource allocation associated with rebuilding our second largest city, we also have to adjust to heavy capital inflows that cause our exchange rate to appreciate and reduce the profitability and competitiveness of our tradables sector.
"And we need to do so at a time when house price inflation is increasing risk in the New Zealand financial system.
"Many of these challenges will be with us for some time. Meeting our price and financial stability objectives, will require us to draw on the full array of policy instruments, including macro-prudential instruments, as appropriate."
Mr Wheeler said that the exchange rate and the housing market present difficult challenges for monetary policy when both the currency and asset prices appear to be overvalued and investor demand is expected to remain strong.
"New Zealand's exchange rate is significantly overvalued. Fortunately it has retreated a little in recent weeks with a stronger US dollar.
"However, investors seem undeterred by the fact that our exchange rate is over-valued, the current account deficit is sizeable and private sector external indebtedness is high. For the current exchange rate to be sustainable in the long term, sizeable increases in the terms of trade and/or productivity would be needed.
"Investors also appear to downplay the liquidity risks inherent in a small market like New Zealand. This is reflected in our past exchange rate cycles that have exhibited substantial overshooting followed by sharp and rapid exchange rate depreciation.
"The Reserve Bank has been responding to the rising exchange rate through two avenues: in maintaining the Official Cash Rate (OCR) at an historically low level; and through a degree of currency intervention.
"The downward pressure on inflation exerted by the high exchange rate means that the OCR can be set at a lower level than would otherwise be the case. In recent months we have undertaken foreign exchange transactions to try and dampen some of the spikes in the exchange rate.
"But we are also realistic. We can only hope to smooth the peaks off the exchange rate and diminish investor perceptions that the New Zealand dollar is a one-way bet, rather than attempt to influence the trend level of the Kiwi. We are prepared to scale up our foreign exchange activities if we see opportunities to have greater influence."
Mr Wheeler said that the Bank is also concerned about the financial stability risks associated with the housing market, in particular the scale of housing lending, and especially high loan-to-value ratio (LVR) lending.
"Risks associated with excessive housing demand could normally be constrained by raising official interest rates and letting them feed through into higher mortgage costs. However, this would carry significant risks of a further strengthening in the exchange rate and further downward pressure on tradable goods prices. This might, in turn, be expected to push CPI inflation further below the 1 to 3 percent target range.
"This is where macro-prudential policies can play a useful role in promoting financial stability. Capital and liquidity overlays can help build up buffers in the banking system while adding to the cost of bank funding. And loan-to-value restrictions may help to reduce the actual supply of mortgage lending.
"If house price pressures abated, it would increase the possibility that the OCR could remain at its current level for longer than through this year. Similarly, if housing pressures are much less of a concern and the exchange rate continues to appreciate and the inflation risk looks low, it may create opportunities to lower the OCR," Mr Wheeler said.
"Macro-prudential measures can be useful in helping to restrain housing pressures, but they are no panacea. This reinforces the importance of measures to enhance productivity in the construction sector, free up land supply, and examine related tax issues."
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