Kiwi dollar strength continues to defy RBNZ strategy
- The RBNZ’s economic forecasts show weaker NZD essential for 2% inflation
- Q3 CPI update will show rate of inflation has slipped into negative territory
- Intervention in the FX market remains an (unspoken) option for RBNZ
By Max McKegg
A combination of a generally weak US dollar, high prices at the latest global dairy trade auction and a strong labour market report saw NZDUSD spike back up to 0.7320 early in the Asian trading session today.
After a period of consolidation, momentum looks likely to take it further still, much to the chagrin of the Reserve Bank of New Zealand which is desperate to see the Kiwi knocked off its perch.
Whole milk powder prices are now up 30% in the last month, driven by lower production in the European Union and increased demand from China. The unemployment rate has dropped to 5.1%.
The RBNZ’s economic forecasts, released in last week’s Monetary Policy Statement, showed that a lower exchange rate is essential if the 2% inflation target is to be reached.
New Zealand’s central bank was the instigator of inflation targeting back in the late 1980s, and since then its become the global orthodoxy.
But as the instigator, the RBNZ has more credibility at stake than most. It’s not a good look then that the Consumer Price Index (CPI) has not only undershot the 2% target over the last four years but has fallen well under the allowed for 1%-3% margin of error.
Not surprisingly, markets have begun to doubt the Bank’s resolve and so, keen to regain the initiative, last week RBNZ governor Graeme Wheeler cut the policy rate cut to 2% and promised more to come, while at the same time issuing forecasts showing inflation rising back up to the objective by mid-2018.
As the chart below shows, this will require a sharp turnaround, one that is not credible without a decline in the exchange rate.
That credibility will be tested further when the next inflation update is released on October 18.
Early estimates from private sector economists suggest the third quarter CPI update will show the annual rate of inflation has slipped into negative territory, in contrast to the RBNZ’s forecast of a slightly positive number.
Either way, markets have taken on board Wheeler’s forward guidance and fully priced in a rate cut at the Bank’s November 9 policy review, to coincide with updated forecasts. The chance of a move at the prior meeting on September 22 are only 25%, but those odds will increase if NZDUSD sustains a move over 0.7300.
The RBNZ is being forced to play catch-up with its G10 counterparts or face the prospect of the exchange rate remaining elevated, in turn eliminating any prospect of achieving the inflation target.
Yet even with the policy rate down at a record low, New Zealand’s yield curve continues to attract both real money and hedge fund capital flows as the “yield convergence” trade takes hold, driving spreads down, as shown in this chart.
Offshore investors now own two-thirds of the local government bond market.
Source: Reserve Bank of New Zealand
Engineering a decline in the exchange rate is key to the Reserve Bank’s inflation forecast. But as the chart below shows (click to enlarge) it’s not as simple as just cutting the policy rate by 25 basis points every now and then.
Previous cuts have had little impact, nor indeed did last week’s. The Bank made a major error in 2014, raising interest rates by 1% to counter a perceived inflation threat that never materialised, at a time when the other G10 central banks were on hold or easing.
So they left themselves with a lot of catching up to do if New Zealand’s rate curve was to cease shining out like a beacon to yield-starved foreigners.
The chart also shows the trajectory line the exchange rate (as measured by the Trade Weighted Index) needs to take to boost import prices and drive the inflation rate up to 2% by mid-2018.
The RBNZ wants to see it down to that line, and preferably under it, sooner rather than later.
But in a global deflationary environment, no central bank can rely solely on import price increases to boost inflation.
In New Zealand’s case, about half the Consumer Price Index is made up of goods and services not subject to international competition, so the Reserve Bank is hoping that lower interest rates will provide a further boost to a domestic economy already expanding close to its potential.
That should should put upwards pressure on wages in the construction and services industries and eventually trigger cost push inflation.
When an economy is expanding at its potential labour and capital resources are fully employed.
In other words the “output gap” is zero and faster growth can only occur at the expense of inflation. As this chart shows, New Zealand is unique among developed economies in that its economy is already expanding at potential.
Lower interest rates are projected to give it another kick along.
Source: Reserve Bank of New Zealand
Events are conspiring against the RBNZ in its attempt to lower the exchange rate. Dairy prices are rebounding, global bond yield yields remain at rock bottom and hopes the US Federal Reserve will ride to the rescue with rate hikes are fading.
Intervention in the FX market remains an (unspoken) option but timing and tactics would be crucial.
A window of opportunity exists on Monday mornings local time (Sunday night in the northern hemisphere) when the RBNZ would have the market to itself.
-- Edited by Adam Courtenay
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him.