With a weak NZ dollar harming the outlook for imported inflation, could the RBNZ be tempted to intervene to try and prop the NZ dollar up?

With the New Zealand dollar taking a battering at a time the Reserve Bank is striving to reduce the highest inflation in 32 years, could the central bank be tempted to intervene in the currency markets in an effort to prop the Kiwi up?

A weaker NZ dollar comes at a bad time for the Reserve Bank. That's because it worsens the outlook for tradable, or imported, inflation stemming from the likes of petrol, food and clothing. For the June year tradable inflation weighed in at 8.7%, the biggest annual movement since the Statistics NZ series began in June 2000. It was a major factor in the overall annual Consumers Price Index (CPI) inflation rise of 7.3%, the biggest increase in 32 years.

BNZ Head of Research Stephen Toplis noted this week that: "At the time of writing the NZ Dollar Trade Weighted Index was sitting at 67.5. This is 5.9% below where the Reserve Bank had assumed it would sit. If it stays here that could add as much as 0.6% to CPI forecasts, which is clearly unhelpful."

The Reserve Bank has increased the Official Cash Rate (OCR) to 3% from 0.25% last October as it strives to get CPI inflation back into its 1% to 3% target band, and is expected to lift the OCR by another 50 basis points next Wednesday, October 5.

At the time of writing the NZ dollar is at US57.19c, having been above US70c as recently as March. Over the past decade it has ranged from a high of US88.21c in July 2014 to a low of US56.08c in March 2020, challenging that low as recently as Wednesday.

To assist its monetary policy inflation fight, might the Reserve Bank be considering currency market intervention, buying the Kiwi dollar, to try and prop it up?

Kiwibank Chief Economist Jarrod Kerr doesn't think so.

"It's a lot easier to sell your currency because you can print as much of it as you like and sell it to get it down. It's much harder to prop up your currency because you have to use your foreign reserves to do so, and my understanding is we don't have much in the way of foreign reserves, probably about $10 billion," says Kerr.

He points out that the main story in currency markets at the moment is the strong US dollar, so effectively the Reserve Bank would be fighting the US Federal Reserve, and a global push into US dollars as a safe haven and the world's reserve currency.

The Fed, Kerr says, is a central central bank that has proven itself to be "quite assertive" in its monetary policy tightening. The Fed has increased the Federal Funds Rate, its OCR equivalent, to a range of 3% to 3.25% from a range of 0.25% to 0.50% as recently as March. 

"That interest rate advantage that we had against the US dollar has evaporated. So that's a big reason why the Kiwi has come off," says Kerr. "Most of the world's currencies have come under pressure against the US dollar."

Jason Wong, BNZ's Senior Markets Strategist, also doesn't expect any Reserve Bank currency markets intervention. Wong says Reserve Bank Governor Adrian Orr's comments on the NZ dollar to date recognise there isn’t much the Reserve Bank can do to affect its value on a sustainable basis.

"I can’t see any level that the Reserve Bank would step in to intervene. If he [Orr] was truly worried about its downward path, then given the inflationary backdrop the most sensible policy would be to counteract that with higher interest rates," says Wong.

How about a 75 basis points OCR hike?

While most economists, including Kerr, expect a 50 basis points OCR increase when it's next reviewed by the Reserve Bank on October 5, Kerr says a 75 basis points increase might be considered due to the weak Kiwi dollar.

"I think so because it's frustrating our tradables [inflation] forecast. We've had a lot of things moving in the right direction for us, we've had a cooling in commodity prices to some extent and the expectations of where commodity prices go is in our favour. Shipping costs have come off quite a lot. So imported inflation looks like it has peaked and looks like it's going to head south into next year and that's great. But obviously that has been frustrated by the drop in the Kiwi currency," Kerr says.

Whilst a weak NZ dollar is good news for exporters and tourism, Kerr notes the vast majority of the economy is dealing with much higher interest rates, very high inflation and a lack of confidence.

The Reserve Bank has intervened in the currency markets from time to time in the past. One such example was in April 2013 when it sold NZ$256 million in a move that proved quite effective in weakening the NZ dollar, which was trading as high as US86c.

A Reserve Bank spokesman says the central bank generally doesn't comment on operational aspects of foreign exchange activities. He notes any currency market intervention would need to be consistent with the Reserve Bank Monetary Policy Committee’s Remit.

Additionally the spokesman says the new Reserve Bank Act requires the Reserve Bank and the Minister of Finance to agree on a framework for the management and use of foreign reserves.

"In light of this, we are in the process of undertaking a comprehensive review of our foreign reserves management framework which will include governance arrangements, the objectives of holding foreign reserves, funding arrangements, and reserves adequacy," the spokesman says.

RBNZ could intervene 'if the exchange rate is exceptionally and unjustifiably high or low'

The Reserve Bank spokesman also points to a 2004 speech by Orr when he was Reserve Bank Deputy Governor and Head of Financial Stability. In the speech Orr said at times the NZ dollar has varied by far more than can be justified by relevant economic fundamentals.

"It is at these exceptional and unjustifiable levels of the exchange rate that the Bank would consider buying or selling foreign currencies for NZ dollars in an effort to influence the level of the exchange rate. There is no mechanical rule underlying this new objective - such decisions are made in context," Orr said.

"An important part of the Bank's consideration to intervene would be the dynamics of the foreign exchange market at the time and whether we feel our actions will be effective. In other words, the Bank would intervene at opportune times, not when the currency's direction is being dominated by strong international trends or consensus opinions."

"We do not intend wasting our reserves by defending a particular exchange rate level, nor do we intend standing in the way of strong market trends or beliefs. We also do not expect to attract speculators who think they can `take the Bank on'. If we are not defending a particular level of the exchange rate, we have no mechanical rule, and we intervene consistent with our monetary policy objectives at opportune times, then it is unclear what nature of speculator would be attracted by our actions," said Orr.

Orr noted an intervention strategy would be consistent with the Reserve Bank's primary objective of achieving and maintaining price stability.

"Hence, foreign exchange intervention can be viewed as another instrument for the Bank, consistent with achieving our monetary policy objectives, albeit a very secondary instrument to our most powerful one of the Official Cash Rate. Intervention would be considered in reasonably infrequent circumstances, that is, when the exchange rate level is exceptional and unjustified by economic fundamentals, and when we believe an opportunity to be effective exists."

The Reserve Bank would contemplate intervening, Orr said; "if the exchange rate is exceptionally and unjustifiably high or low, and we think an opportunity exists that would ensure such intervention was effective."

"By exceptionally high or low, we mean when the exchange rate is nearing its cyclical extremes, as has been seen in New Zealand over recent decades on a three to five year cycle. By unjustifiable, we mean when the exchange rate has moved well in excess of any relevant economic fundamentals, such as relative productivity, commodity prices, growth, or inflation," said Orr.

He added that most of the time NZ's floating exchange rate performs important economic functions such as acting as a buffer against shocks to the terms of trade or relative business cycle pressure.

"We believe our floating exchange rate serves New Zealand well," Orr said.

Meanwhile Kerr notes that the Kiwi dollar always underperforms in a world with weakening risk appetite.

"The Kiwi dollar loves growth and confidence – even irrational exuberance. Whereas traders are quickly reminded that the Kiwi is a flightless bird when risk sentiment turns south," says Kerr.