Roger J Kerr argues the only monetary policy option left for the RBNZ is to force the NZ dollar's value down by intervening in the currency markets

By Roger J Kerr

Today’s super low inflation numbers for the March quarter will only intensify the debate as to whether short-term interest rates in New Zealand controlled by the RBNZ should be reduced, increased or kept the same over the next 12 months.

Many will argue the near to zero annual inflation rate is as good as the deflation pervading in Japan and Europe at this time and therefore interest rates should be cut for the good of the economy (particularly exporters, as a cut would lower the NZ dollar value).

The argument against cuts and in favour of the status quo and increases in interest rates later on, is that the sharply rising values in the residential property market increases consumer demand though the wealth effect and thus is a major risk for future inflation.

Of course, a cut in the OCR at this time would add fuel to the property market fire by further reducing mortgage interest rates.

As always, there is no one single answer to this extreme dilemma the RBNZ finds itself in. Deputy Governor, Grant Spencer’s speech last week sent a message to the Government that they have to do more on the policy front (tax, RMA) to address the risks that the speculative investment into the housing market presents.

The RBNZ looks set with the next phase of their macro-prudential tools to force the banks to charge higher commercial interest rates for mortgages on residential investment properties. That additional cost will be passed on to the tenants in increased rents and is unlikely to dent the pursuit of tax-free capital gains by the speculators. In the end, natural supply and demand forces that are driven by price, and determine price, correct themselves. The question is whether the bubble bursts with serious collateral damage, or it can be managed to slowly deflate.

What should the RBNZ and the Government do right now do to prevent a nasty bursting of the housing market bubble disrupting financial stability and the economy?

What the RBNZ should do

Normally in this situation the RBNZ would be shunting interest rates up to slow the economy and house price inflation. They cannot do that as it would just push the NZ dollar higher when the rest of the world is cutting interest rates and printing money. The overall value of the NZ dollar, the TWI Index, has returned to its highs of 80.00 with all the major cross-rates increasing and the NZD/USD rate moving up to 0.7700. The RBNZ cannot cut interest rates and cannot increase interest rates.

Therefore the only monetary policy option left is to force the NZ dollar value down. It will require more than just jawboning words of “unjustifiably high” and “unsustainably high” to scare the currency traders and depreciate the NZ dollar. The time has come for the RBNZ to intervene again directly in the FX markets by selling the NZ dollar, as they did last August.

The pre-conditions and prerequisites for currency intervention are currently fulfilled in my book.

Specifically, before intervening the RBNZ will need to be satisfied that all of the following criteria are met:-

• The exchange rate must be exceptionally high or low; Tick! - RBNZ TWI assumptions are 75.
• The exchange rate must be unjustified by economic fundamentals; Tick! – The RBNZ has been telling us this for a while now. Dairy prices and the Terms of Trade Index are down.
• Intervention must be consistent with the PTA. Tick! -  The inflation rate is not going to be forced above 3.00% by selling the Kiwi dollar down to 0.7200 and the TWI to 75.
• Conditions in markets must be opportune and allow intervention a reasonable chance of success - their judgment call – However, a nudge lower in the NZD/AUD cross-rate right now would stimulate a massive unwinding of long NZD positions against the AUD i.e. heavy consequential NZD selling.

The risk of RBNZ intervention forcing the NZ dollar lower on its own accord is elevated once again.

What should the Government do?

They have been trying to increase the supply of land for new house builds in Auckland with some success. They will not control immigration or bring in a capital gains tax. They could give the IRD more enforcement powers over those investors trading residential properties and who are not declaring the income for taxation on such business activity. They could also do more to encourage economies of scale with standard house construction designs/materials to lower the build cost to Aussie levels.

The Government would be better advised to address these issues than merely applauding the NZ dollar nearly reaching parity with the AUD as they did last week!