What can the Reserve Bank do about the exchange rate?

(This isn’t the follow-up post on real interest rates.)

A commenter on interest.co.nz , referring to my piece on the exchange rate the other day, posed the following question:

It is gratifying to see an apparently reputable NZ economist such as Reddell explain the long term effects of an overvalued exchange rate, and that the NZD is still overvalued. I had thought NZ economists, perhaps for political reasons, remained in denial on this point. Does he have a view, do we know, whether the Reserve Bank could be more active in encouraging the exchange rate down, other than occasionally attempting to talk it down?

I think the second sentence is a little unfair, although it does depend what people mean by “overvalued”.  Most prominently, Graeme Wheeler routinely highlights that the exchange rate appears out of line with long-term fundamentals.

On the question the commenter poses, I do have view and the answer is “typically not”.  At present, I think the Reserve Bank has the OCR set too high, and will need to lower it.  At the margin, the overly tight monetary policy in recent years has left the exchange rate a little higher than otherwise.

The other instrument the Reserve Bank has at its disposal is foreign exchange intervention.  I have come and gone over the years on whether the Bank should be able to do such intervention, but no one believes it can make any material or sustained difference to the sorts of real exchange rate misalignment I was talking about in the earlier post.

Central banks can do things that make a difference to the real exchange rate for short periods of time.  Monetary policy makes more difference than intervention.   But sustained misalignments, over decades, are real phenomena, not monetary ones.  To understand those sorts of sustained pressures, one needs to look to what drives differences in real interest rates over long periods.  And, again, the answer isn’t monetary policy (as the Bank explained here).  Regulatory policy doesn’t make much sustained difference either, although there are some intriguing suggestions to the contrary here.

6 thoughts on “What can the Reserve Bank do about the exchange rate?

  1. I think the answer may lie buried in this paper from the BIS:

    My simple summary is as follows: you need to channel money to a group in society who will save it. So Germany effectively channels money to the Mittelstat owners who save it rather than spend it. The key insight here is that these are the people in society who are most likely to have a productive use for the savings.

    What I think policy makers and non business owners don’t seem to understand is that it is bloody hard to make a profit. All the forces of society act to get you to spend too much on the wrong things. It is even harder to find things to invest in that will give a real productive return. Everyone thinks they understand this but in reality they do not – most “investments” are not productivity enhancing but merely redistribute existing wealth via capturing the economic rent via borrowing and inflation. It is so much easier to make money in leveraged property than it is in manufacturing.

    What to do from a policy perspective? Seriously the most useful thing would be to reduce the corporate tax rate to say 12%. Existing businesses would be able to invest in real productivity enhancing equipment or research and development. The government would get more tax revenue from income tax with a lag. If you want to be really radical then make the corporate tax rate 12% and abolish the tax deductibility of interest. Then the profitable will grow and the rent seekers will not.

    What to do from an investment perspective? Be a rent seeker.


  2. Thanks Richard

    It is quite right to focus the discussion in one things that affect savings and investment: they are the things that will affect long-term average real interest rates. I’m quite sympathetic to the idea of a much lower corporate tax rate, altho bear in the mind that they would tend to raise interest rates (more demand for resources for investment) not lower them.


    • Yes, well, my personal view is interest rates have been too low for too long. I favour Rodney Dickens’ view that it is appropriate to lower interest rates in an emergency, but you get them back to the natural rate as soon as possible thereafter. The opposite of optimal control. That way you encourage saving and investment in productive things.

      Something is deeply messed up in New Zealand and low interest rates are part of the problem. From an IRR perspective they sort of extend the time horizon and everyone focuses on being able to make the interest payments rather than being able to pay off the principle. It’s not a real investment if it doesn’t generate the cash flow to pay off the interest and the principal, it’s something else (a delusion, a rent seeking speculation?

      I find it bizarre that the well meaning and intelligent folks at the RBNZ are happy with a scheme that steals from people of modest savings in the regions and gives to those with high incomes in Auckland. That is what holding interest rates down does. People with modest savings lend it to the bank under the delusion that the interest payment is a return on capital, when in fact it is a pure fraud whereby they are paid back their capital in mini dollars. That this is done intentionally by well meaning people is just extraordinary.

      I could rant for hours….


  3. Further to the above, in my enthusiasm I omitted to point out that I think the low interest rates suck in capital via the banking sector thereby pushing up the NZD. It is like a self perpetuating syndrome. Michael Pettis is the guy for this stuff.


  4. Yes, I greatly value Pettis’s work.

    In defence of my former RB colleagues, the government sets the inflation target and they have to set interest rates consistent with that. Higher interest rates in the current climate would pose an increasing risk of deflation. But if the government wants higher interest rates, they can change the target. If on the other hand they want to stop enriching those long land in Auckland then some mix of RMA reform and immigration target cuts would do the trick.


    • I guess the answer to your question about why are interest rates higher in New Zealand is the same as why is the NZD consistently overvalued, ie we are less good at currency manipulation than others. Hence the link to the BIS study above.


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