Monday morning started on an ugly note for much of the business and investment community.
The signs pointed to another gloomy week, with more profit downgrade announcements from exporters, as the New Zealand dollar opened at US76.3c and A90.4c.
The stock exchange also kicked off on a sombre note, and the NZX50 Index was immediately down 0.3 per cent even after the strong Friday close on Wall Street.
But the gloom was short-lived as the NZX quickly moved into positive territory and the kiwi dropped sharply mid-afternoon.
This followed the sale of the NZ dollar by the Reserve Bank because it regarded the exchange rate as “exceptional and unjustified in terms of economic fundamentals”.
The bank’s action was totally unexpected, and raised important questions about the objectives and implementation of monetary policy in New Zealand.
Students learn in Economics 101 that monetary policy is a central bank’s actions to influence the cost of money and credit – through interest rate changes – to achieve economic objectives, particularly price stability or low inflation.
Until recently, finance ministers in most countries were responsible for both monetary and fiscal policy.
Fiscal policy is the Government’s management of the economy through taxation and spending decisions.
In the late 1980s economists began to lobby for the separation of monetary and fiscal decisions because they believed governments loosened monetary policy to ensure economies were buoyant at the time of general elections. They said this led to higher inflation shortly after the elections.
New Zealand was at the vanguard of this movement – mainly because of blatant attempts by former Prime Minister and Finance Minister Robert Muldoon to manipulate interests around the election cycle – and the Reserve Bank of New Zealand Act 1989 came into force on February 1, 1990.
Under this, the Government sets the inflation target, but the Reserve Bank has complete operational independence in deciding how this price stability target will be achieved.
As the table shows, the Reserve Bank has a much narrower monetary policy focus than most other central banks.
Governor Alan Bollard has to take only price stability into account, while the Reserve Bank of Australia has to consider “full employment and the economic prosperity and welfare of the people of Australia”.
The United States Federal Reserve Board has “price stability, maximum employment and moderate long-term interest rates” objectives, and the Bank of England also has “to support the Government’s economic objectives including those for growth and employment”.
The hawkish monetary policy approach in New Zealand is often blamed on the narrow price stability objective in the Reserve Bank Act.
The Reserve Bank has been given an inflation target of between 1 per cent and 3 per cent. The consumer price index increased by 2.5 per cent in the year to March.
New Zealand’s inflation rate has fallen from 4 per cent to 2.5 per cent since the year to last June, yet the Reserve Bank has raised its official cash rate from 7.25 per cent to 8 per cent over the past 12 months.
The Reserve Bank expects inflation to fall over the next few months, and to stay below the 3 per cent top range through to the March 2010 year, yet it continues to adopt extremely aggressive interest rate policies.
The Reserve Bank of Australia has a 2 per cent to 3 per cent inflation target and the country’s CPI rose by 2.4 per cent in the year to March.
The Reserve Bank of Australia expects inflation to be between 2.5 per cent and 3 per cent through most of next year, but it hasn’t raised interest rates since November last year.
The Reserve Bank of NZ expects inflation to be between 2.3 per cent and 2.6 per cent next year yet it has raised rates three times this year.
New Zealand’s inflation rate is in line with the UK, Australia and the United States yet our interest rates are much higher.
Over-investment in housing is a major concern for the domestic economy but is it the Reserve Bank’s role to fight this battle to the detriment of the rest of the economy, particularly exporters?
One of the problems with the Reserve Bank has been its failure to anticipate the strong performance of the New Zealand dollar and its negative effect on exporters. For example:
* In its March 2004 monetary policy statement, the bank forecast a trade weighted index of 64.25 for the first half of 2005. The average for that period was 70.2.
* In September 2004 it predicted that the index would be 65.5 in 12 months, but it was 70.6.
* The September 2005 statement had a second-half 2006 forecast of 63.25; it was 65.3.
* In March last year, it predicted 62.5 in the first half of this year, but the index is now above 73.
In light of its poor forecasting record, it was surprising the Reserve Bank entered the foreign exchange market and boldly declared that it regarded “current levels of the exchange rate as exceptional and unjustified in terms of the economic fundamentals”.
It was also unexpected in view of the bank’s limited financial resources and the huge amounts of money available to overseas foreign exchange participants.
The Bank of International Settlement surveys the world’s foreign exchange markets every three years. The last one, which is nearly three years old, concluded that the average daily turnover was US$1773 billion. The Kiwi was ranked thirteenth in terms of volume with a daily turnover of US$18 billion ($24 billion).
Daily turnover on the NZX often struggles to surpass $100 million.
A recent study by London-based International Financial Services estimates that daily global foreign exchange turnover has ballooned to US$2900 billion – more than 10 times the combined turnover of the world’s sharemarkets.
The kiwi represented about 1 per cent of world turnover three years ago and, if this percentage has been maintained, its daily turnover is now around US$29 billion ($39 billion).
The country’s annual exports and imports are worth $77 billion – about two days of kiwi turnover.
The Government has agreed to cover Reserve Bank losses from currency intervention of up to $1 billion, suggesting the Reserve Bank could have about $5 billion at its disposal for intervention, although this has not been made public.
This is minuscule in relation to foreign exchange market turnover and estimated unleveraged worldwide hedge fund assets of US$1500 billion ($2000 billion).
The relatively small size of the Reserve Bank indicates that its foreign exchange market intervention is not sustainable, and we need a fresh approach to monetary policy.
The Reserve Bank should intervene in foreign exchange markets only when there is a crisis – yet the current “high NZ dollar crisis” has been caused by the bank through its high interest rate policies.
In this regard, the recent announcement that Parliament’s finance and expenditure committee is conducting an inquiry into monetary policy is important.
The committee’s first recommendation should be to widen monetary policy objectives beyond the single goal of price stability.
We should adopt the Australian, UK and US models and force the Reserve Bank to take economic growth into account when implementing monetary policy.
This would compel it to consider wider economic interests, including the position of exporters, when making interest rate decisions.
Central Bank monetary policy objectives & interest rates: The RBNZ has a narrow focus
|Rates*||Inflation||Monetary Policy objectives|
|Bank of England||5.5%||3.1%||Price stability & support the Government’s economic objectives including those for growth and employment|
|Bank of Japan||0.5%||0.0%||Price stability only|
|European Central Bank||4.0%||1.9%||Price stability, a high level of employment & sustainable and non-inflationary growth|
|Reserve Bank of Australia||6.25%||2.4%||Price stability, full employment & the economic prosperity and welfare of the people of Australia|
|Reserve Bank of NZ||8.0%||2.5%||Price stability only|
|US Federal Reserve Board||5.25%||2.6%||Price stability, maximum employment & moderate long-term interest rates|
*Official central bank interest rates. Source: Milford Asset Management