Exchange rate impervious to monetary policy

Alerting monetary policy to adjust the exchange rate would be counterproductive and harmful to future growth, according to Dr John McDermott, Assistant Governor and Head of Economics at the Reserve Bank of New Zealand (RBNZ).

Speaking at the Financial Services Institute of Australasia on ‘The role of forecasting in monetary policy,’ in Wellington recently, he said that New Zealand’s exchange rate has been the subject of angst and debate.

“The fact that the average income in New Zealand has failed to converge with the rest of the advanced world over the past few decades has also attracted attention, and has been a subtext to the angst about the exchange rate,” he said.

Tight policy

Dr McDermott discounted the view expressed in some circles that the volatility in exchange rate would vapourise with a change to the monetary policy.

“The hard-won monetary policy lessons of the last quarter of a century demonstrate that we cannot generate sustainably more growth (in the real economy or in exports) by keeping monetary policy unjustifiably loose. Any attempt to do so would create future inflationary problems that would be costly (in terms of growth and employment) to resolve,” he said.

While he agreed that the New Zealand economy faced some serious challenges, warranting changes in some areas, tampering with the monetary policy would have serious consequences.

In his address, Dr McDermott outlined the underlying causes for the overvalued exchange rate, saying that monetary policy would be redundant in an economy, which always enjoys full employment and an inflation rate that is always on target.

But experience has proved that reality is otherwise.

Surplus & Deficit

“Suppose however that savings are insufficient to fund the investment needs of this economy, like New Zealand over the last 40 years. With access to global capital markets, this economy can fund its investment needs by borrowing from the rest of the world. The result is a capital account surplus. If foreign investors have any home bias in their investment decisions, then the more foreign savings that are demanded, the higher the interest rate the domestic economy needs to pay,” he said.

“But because the overall balance of payments is by definition always zero, this capital

account surplus requires a current account deficit. The exchange rate is the price that will yield a level of exports and imports to meet this requirement and therefore the exchange rate will be more appreciated.”

According to Dr McDermott, in such a framework, a lack of savings, relative to investment needs, yields a prediction of domestic interest rates higher than the global average, a high exchange rate and a persistent current account deficit.

Stylised story

“This prediction matches the stylised features of the New Zealand economy over the past 40 years. It is worth noting that in this stylised story, monetary policy played no role in generating such an outcome,” he said.

He said that many voices are often heard, stating that New Zealand is suffering from a surge in unwanted capital inflows resulting in an overvalued exchange rate that in turn causes damage to exports and thus the economy’s growth potential.

“While there may be temporary surges from time to time, what we would have expected to see – if this had been a persistent problem – is lower interest rates than in the rest of the world and a high exchange rate,” he said.

Dynamic economy

Dr McDermott said that the New Zealand economy is never at rest and hence “output can cycle around its fully employed potential and inflation can cycle around its target.”

“These cyclical dynamics can generate volatility in the exchange rate. Moreover, given that exchange rates tend to move much faster than the prices of goods and services, any disturbance to the economy (whether trade related or not) can be reflected in the exchange rate overshooting its long-term fair value,” he said.

Editor’s Note: The above is only an extract of Dr John McDermott’s speech. For full text, please visit www.rbnz.govt.nz

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