Goff's ideas to tame the kiwi may backfire

OPINION: The leader of the Opposition has stated that if elected prime minister he intends forcing the Reserve Bank to focus less on inflation and more on currency stability, writes Tony Alexander this week.

If you truly believe he will do this, it would seem a good idea to do two things – buy houses and ship spare money out of New Zealand.

We don't for a second believe Phil Goff is thinking in terms of inflation above 5 per cent. But he could be thinking about something close to that because over the past four years New Zealand inflation has averaged 3 per cent so presumably that is at a minimum of what he is dissatisfied with.

House prices tend to rise by an amount above the rate of inflation, while fixed-interest deposits tend to depreciate in real value. Therefore his comments – if believed – are likely to accentuate upward pressure on house prices in the next few years. This will make home ownership even more difficult for low-income earners who tend not to have the same ability as those on higher incomes to keep their incomes up with cost of living rises – which is another name for inflation.

And why ship funds out of New Zealand? Because New Zealand led the world in targeting low inflation and there is still a gradual movement under way globally toward giving central banks just the one goal rather than a mishmash of targets changed at the whim of the politicians.

If New Zealand sticks out as abandoning low inflation then one would expect investors to demand a higher risk premium for investing here – hence the lower New Zealand dollar.

Exporters may be thinking that is a good thing – but they should think again. Inflation is another name for cost of living increases which is another name (roughly) for cost of business increases given the additional upward pressures on wages and other input costs like electricity, transport and rates.

Higher inflation means higher cost increases for exporters and only if the kiwi depreciates will they be compensated. History shows that depreciation is likely – but it is impossible to know when it will occur, and it usually happens in sharp movements rather than gradual steps.

Currency volatility would be increased by targeting higher inflation and not reduced.

Is there anything that can be done about the volatile New Zealand dollar? First – it is a physical impossibility to fix the rate unless all export, import, dividend, interest payment/receipt, tourism spending and all other foreign exchange transactions were centrally controlled. One suspects we highly migratory Kiwis would not stick around in such a police state.

The Reserve Bank has tried to smooth the New Zealand dollar's peaks – with no sustained success in 2007 near the US 75 cent mark. The currency initially dipped then soared to a new high against the US dollar of 82 cents in March last year.

Reserve Bank intervention does not work. Jaw-boning by the Reserve Bank, the Prime Minister and Minister of Finance has also been shown repeatedly not to work – but it sells well down on the farm.

One could alter interest rates – but this would mean inducing huge uncertainty in household mortgage payments, business debt servicing costs, and increasing housing market volatility. And if the kiwi can rise from US49 cents to US76 cents this year while the official cash rate is cut from 3.5 per cent to 2.5 per cent, then clearly interest rates are not always a key driving force – as we have so strongly tried to tell exporters for most of this year when encouraging increased hedging.

One could tax inward investment flows. Think about that one. Banks are already restricting access to credit because their ability to raise funds offshore has permanently deteriorated. A new tax would scare even more investors away and push domestic interest rates even higher for business and household borrowers. One suspects the farmers with floating-rate debt might not like that.

There is nothing solid going to come along in the next few years which will reduce New Zealand dollar volatility. That is why we remain such strong advocates of hedging.

» Tony Alexander is the chief economist for the Bank of New Zealand.

- © Fairfax NZ News

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