Steen Jakobsen
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Article / 12 July 2016 at 2:57 GMT

FX market intervention might be the only way out for RBNZ

Managing Director / Technical Research Limited
New Zealand
  • Market forces are driving up NZ's exchange rate and house prices
  • This is affecting the RBNZ Governor's inflation target and financial stability mandate
  • A course of action is needed by the next monetary policy review on August 11
  • One option, although fraught with danger, is an intervention in NZDUSD

By Max McKegg

Central bankers worldwide are undergoing trial by fire, but a special place in purgatory seems to have been set aside for Reserve Bank of New Zealand Governor Graeme Wheeler. Personally responsible for monetary policy – there is no officially appointed “Committee” – Wheeler finds himself firmly lodged between a rock and a hard place as market forces drive up the value of New Zealand’s exchange rate and house prices at the same time; the former a risk to his inflation target, the latter to his financial stability mandate.
What’s a man to do? One, cross his fingers and hope a resurgent US dollar will drive NZDUSD down? Two, hold the policy rate at 2.25%, suck “flight from negativity” flows into the NZD and, via higher import prices, wave goodbye to his 2% inflation target? Three, cut the rate to 2% in an attempt to lower the exchange rate and, via higher import prices, give inflation a boost – but at the same time throw more fuel onto an already red-hot housing market? Or, four, introduce draconian lending restrictions on housing, risking a crash that could cause financial instability?

 Between a rock and a hard place. The RBNZ Governor has some 
tough decisions to make. Photo: iStock
Wheeler must decide which of these options to go with at the Reserve Bank’s next monetary policy review on August 11.
But is there a “third way” or another option the normally conservative Governor could pursue, albeit one fraught with danger, and that is an intervention in NZDUSD.
Economists generally agree the New Zealand economy doesn’t need a rate cut: GDP is expanding close to its potential of 3%, driven by buoyant consumer spending, high immigration and booming tourism. The unemployment rate is close to its natural level and wage pressures are mounting in some areas. This also makes it difficult for the RBNZ to justify intervention in the currency market as it would be hard to argue the current level is “unjustified based on a range of economic variables” – because those variables extend further than just under-par inflation.
In fact, it is arguable that the strongly performing economy is as much a cause of the currency strength as are interest rates. Regardless, as shown in the chart below, NZD stands out as offering the best carry among the most highly traded currencies, especially since the US curve started to level out as markets lower the probability of rate hikes this year.


Source: Bank of New Zealand 
Little surprise then that the overall measure of the NZD, the Trade Weighted Index is surging ahead, as shown in this chart below (click to enlarge). The TWI has moved up over 77, about 7% higher than where the Reserve Bank projected it would be in economic forecasts presented in their June Monetary Policy Statement

NZDUSD is not the only guilty party: the kiwi has been rallying harder than the Aussie, driving NZDAUD up close to record levels, and the surreptitious devaluation of the Chinese yuan is also having an impact, given NZDCNY’s high weighting in the TWI.

Source: Reserve Bank of New Zealand, Metastock
The effect of the TWI being so far above the Reserve Bank’s projection will show up in headline inflation numbers over the next few months, perhaps knocking 0.4% off the year-on-year number. 

That’s significant: next Monday (July 18) the June quarter Consumer Price Index numbers will be released and are expected to show the annual rate of inflation rising from close to zero to about 0.6%. The Bank had been hoping a downward trending exchange rate would give the annual rate a further nudge, seeing it back up into the 1-3% target band by the end of this year. But instead, unless by good luck or good management the kiwi dollar reverses recent gains, the inflation rate will drift back down. 
In its June Monetary Policy Statement, the RBNZ’s baseline forecast (central projection) was that inflation would move back to the mid point of the target range without requiring the assistance of any significant change to interest rates; perhaps a cut from 2.25% to 2.00% somewhere along the line if global conditions deteriorated. 

But the Bank also outlined two scenarios where interest rates diverged markedly from the central projection. In scenario one, the exchange rate did not decline as expected this year and to compensate, the policy rate would need to be cut to 0.75%, as per the green line in the chart below. In scenario two, the housing market boom accelerated, consumer spending rose in line with the wealth effect, economic growth exceeded potential and inflationary pressures emerged. If so, the policy rate would have to rise above 3%.
But what happens if both scenarios are playing out at the same time, as appears to be the case now? That’s the dilemma Governor Wheeler finds itself facing.


Source: Reserve Bank of New Zealand
The Reserve Bank of New Zealand finds itself stuck between a rock and a hard place. House prices and the exchange rate rising at the same time require opposite monetary policy responses. 

Cut interest rates to lower the NZD and you throw more fuel on the real estate boom; hold rates steady and the carry trade takes NZD higher still, lowering the inflation rate. A “third way” would be for the RBNZ to intervene in the FX market and knock the kiwi off its perch. But to do so Governor Wheeler would have to declare the exchange rate was “exceptionally high” and then wait until market conditions were “opportune, so that intervention has a reasonable chance of success”.
– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.


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