09 June 2016 at 1:49 GMT
- NZDUSD rallies to 0.7135 after official cash rate is held steady at 2.25%
- The currency response surprises many analysts and will frustrate the RBNZ
- The Trade Weighted Index pushes up over 75
- Updated inflation forecasts have headline rate at bottom of 1%-3% target by year end
By Max McKegg
The New Zealand dollar
jumped across the board today; a slap in the face to the Reserve Bank of New Zealand, which need a lower exchange rate to achieve its inflation target. The impetus came from the bank’s quarterly Monetary Policy Statement
and follow-up press conference by Governor Graeme Wheeler during which he said “no further policy response is required at this stage”. NZDUSD
rallied about 100 basis points to 0.7135 after the official cash rate was held steady at 2.25%.
The RBNZ acknowledges a rise in overall inflation driven by tradeables is as much a hope as an expectation. Photo: iStock
The currency response surprised many analysts as money markets had priced in only a 25% chance of a rate cut. Furthermore, unlike the case with the Reserve Bank of Australia on Tuesday, the RBNZ maintained its easing bias, saying, “Further policy easing may be required to ensure that future average inflation settles near the middle of the target range.”
The problem with the exchange rate is illustrated by this chart of the Trade Weighted Index (TWI) . The TWI pushed up over 75 today, driven by the crosses that have the highest weighting: NZDAUD, NZDCNY and NZDUSD.
NZ Trade Weighted Index – click to enlarge
The Monetary Policy Statement included updated inflation forecasts showing the headline rate reaching the bottom of the 1%-3% target band by the end of this year and pushing up to the mid-point by late 2017. The trouble is that outcome is largely conditional on the TWI tracking down over the next couple of years, as shown in the chart. Thus the index needs to average 72.6 over the June quarter, about 4% lower than where it sits today.
All else being equal, a declining exchange rate would result in higher prices in NZD terms for imported goods, including oil, thus dragging up the “tradeables” component of headline inflation, as illustrated in the chart below. That impact could be tempered if disinflationary conditions were to continue in the global market place. Thus the RBNZ acknowledges a rise in overall inflation driven by tradeables is as much a hope as an expectation.
The bank says its monetary policy has more impact on the non-tradeables component of overall inflation, that is price movements in goods and services not subject to international competition. Domestic inflationary pressure can be generated by ensuring the economy is running at or above its potential – in other words using monetary policy to ensure labour and capital resources are being fully employed. An economy is said to be running at its potential when the “output gap” is zero. In most OECD countries the output gap is negative; in New Zealand it has closed up in recent years and the RBNZ forecasts it will move into positive territory as GDP grows over 3% versus an estimated potential of 2.5%. Again, all else being equal, economic theory suggests this is a recipe for both demand-pull and cost-push inflation.
But all else will not be equal if the exchange rate does not trend down. The Monetary Policy Statement offers a scenario in which it holds at around current levels (75 on the TWI) over the next couple of years. The bank says a “monetary policy response” would be required in this situation, along the lines illustrated in the chart below. That is, the policy rate – assumed to go no lower than 2% under the central scenario – would need to be dropped to 1% at least.
On the other hand, if the current immigration-driven boom in house prices continues, leading to above-forecast consumption growth driven by the “wealth effect” (and therefore a more positive output gap), then an interest rate rise would be the appropriate response.
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The reaction in the FX markets to today’s statement will be frustrating for the RBNZ. They will have thought maintaining an easing bias would have been sufficient to keep a cap on the Kiwi dollar. No such luck. Carry traders will be thinking they have an opening to maintain upward pressure on NZDUSD at least until the bank’s next monetary policy review and updated forecasts due for release on August 10.
Asked about the possibility of intervention in the meantime, Governor Wheeler pointed out the turnover in the Kiwi is about $100 bn each day, mostly offshore and mostly in NZDUSD. The RBNZ’s ability to have much impact in such circumstances is limited. In fact, said Wheeler, any activity would need to be opportunistic, looking for trading gaps on days of low liquidity in the cross rate. They are few and far between, however, given NZDUSD is one of the top ten traded crosses.
– Edited by Susan McDonald
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.