Roger J Kerr says the Reserve Bank are still full of inflation problems, but offer no solutions

• Summary of key points: -

• Keeping in perspective the big picture cycles of the US dollar
• RBNZ still full of inflation problems, but offer no solutions

Keeping in perspective the big picture cycles of the US dollar

Since the US dollar traded to its weakest point against the Euro at $1.6000 in early 2008, it has displayed many periods of strength that are typically quite short-lived in time, however average between 20 and 30 cents in extent. Refer to the EUR/USD chart below showing the periods of USD gains against the Euro: -

Example 1: $1.4500 to $1.2500 on three occasions between 2008 and 2013.

Example 2: $1.3500 to $1.0500 in 2015.

Example 3: $1.3500 to $1.0500 and below on two occasions between 2018 and 2022.    

There are numerous reasons for the USD strengthening against the Euro, but they generally boil down to interest rate differences between the two currencies, GDP growth performance differences and global geo-political events. The USD always gains when there is political and security risks/ uncertainties in the world. In September last year, the US dollar appeared to complete its sixth period of a strengthening trend since 2008 at a record high of 0.9500 against the Euro. The Federal Reserve were re-exerting their tight monetary policy at the time by shunting US interest rates higher, precisely as the outlook for Europe looked very dire indeed with a looming winter energy crisis and potential economic catastrophe.

The market sentiment towards the USD and therefore its direction against the Euro changed abruptly in October/November 2022. The US interest rate markets and the FX markets started to sell the USD down as they viewed US inflation as having peaked in mid-2022 and therefore the Fed would eventually stop raising interest rates and if the expected US economic recession was bad enough, they would be forced to cut interest rates (negative for the USD). The USD losses against the Euro from October 2022 to January 2023 were as rapid as earlier periods of USD downtrends. The EUR/USD rate moving 15 cents from $0.9500 as of 30 September to $1.1000 on 31 January. Three successive months (October, November and December) of the monthly US CPI inflation figure printing below prior consensus forecasts was sufficient ammunition for the FX markets to continue to sell the USD as they foresaw the Fed being forced to pause and pivot on monetary policy before too long. In addition, the anticipated economic disaster in Europe never happened, therefore the Euro also gained in its own right as the way was then clear for the ECB to hike interest rates more aggressively.

The sharp pullback in the EUR/USD rate from $1.1000 in late January to $1.0550 today (USD gains) has come about from the FX markets taking some short-term fright from the jumbo (but questionable) 517,000 increase in US jobs in January, plus January’s CPI and PCE inflation measures both printing marginally higher than prior market expectations. We continue to hold the view that the markets have over-reacted to one month’s jobs and inflation data in the US and have pushed interest rates too high and the USD too strong as a consequence.

There is no evidence of inflation in the US re-surging higher again in 2023. Oil prices are stable at lower levels, shipping/freight costs continue to decrease, and US wage increases are subdued. The arithmetic of how inflation is measured means the annual rate of inflation falls steeply when 0.40% monthly increases this year are replacing 1.00% monthly increases last year (which  are falling out of the annual measure). The stronger US economic data in January (highly unusual in the middle of a severe winter) does not result in a new trend that the Fed have to adjust monetary policy to. For that reason, we see the recent USD gains as not being sustainable.

Weaker US economic data and the lower inflation rate over coming months, coupled with the ECB still hiking EUR interest rates, should turn the USD back onto its downtrend. A EUR/USD rate above $1.1700 would break the downtrend line that the Euro has held below since 2008. A return of the EUR/USD rate to $1.2500 would complete a 30 cent USD depreciation from 0.9500, which is not unusual compared to historical patterns. The current USD pullback to 1.0550 looks like a blip on the road to the overall USD downtrend, the USD’s decline was never going to be a nice straight line.

The reasons for forecasts of a stronger USD in 2023 no longer stack up to scrutiny in our view. One of the main arguments was that a global economic recession always results in a stronger USD. With China back at full-noise, Europe recovering and the US economy slowing (but not capitulating), the probability of a global recession is receding every day. Consensus FX rate forecasts for the EUR/USD exchange rate for the end of May 2023 have 20 out of 22 forecasters predicting a weaker USD to around the $1.1000 level.

The NZD/USD exchange rate has maintained a close correlation to EUR/USD movements over the last three years. Therefore, a EUR/USD rate of $1.1000 equates to 0.6600, $1.1500 equates to 0.6900 and $1.2000 equates to 0.7200.

RBNZ still full of inflation problems, but offer no solutions

The RBNZ duly delivered their Monetary Policy Statement last week, with a “no surprise” outcome of a 0.50% OCR increase to 4.75%.

The forward guidance for future OCR increases and the terminal rate were largely unchanged from their November statement. There was little in the way of reaction by FX and local interest rate markets.

A number of local bank and “independent” economists would have been disappointed that their calls for a postponement of interest rate increases due to the Cyclone Gabrielle devastation on the east coast of the North Island was not listened to. It is not the role of monetary policy to cater for selected parts of the economy, even if the emotional response of needing to care pulls you that way. It seems some economists are only about seeking media publicity with contrary views to promote their own social policy agendas, which does not help with a wider understanding of what monetary policy can and cannot do.

Unfortunately, once again, the RBNZ failed to take the opportunity to proffer solutions to bring our crippling inflation rate down. They correctly discuss capacity constraints in the economy pushing inflation higher, however offer no message to their mates across the road in Wellington to immediately adopt progressive immigration policies to increase the supply of labour to address the acute shortages.

The RBNZ again hardly mentioned the exchange rate level, yet at 0.6170 to the USD and a TWI of 70.40, the low value for the dollar is currently adding to inflation. If the RBNZ are serious about delivering on their inflation remit they need to influence (“jawbone”) the exchange rate higher, which would reduce inflation with no economic damage (exporters being highly hedged).

At some point over the next few months, the officials at the RBNZ might wake up and realise that the NZD exchange rate plays a major part in determining our inflation levels, therefore they should apply it as an additional monetary policy tool.

*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has written commentaries on the NZ dollar since 1981.