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Roger J Kerr sees the exchange rate as the main determinant of future inflation and growth, and therefore our interest rates. You agree?
By Roger J Kerr
Whether you are a borrower or investor, considering potential future economic and interest rate market scenarios is always a smart way to manage risk of adverse rate movement.
Such a process has not really been required over recent years as the OCR has been stuck at 2.5% due to earthquakes and the in-demand NZ currency.
The time however may have come to dust off the scenario-testing model to consider how things may be looking in 12 months time.
Believe it or not, the most important determinant of whether 90-day to two-year interest rates will be higher or lower in a year’s time will be the value of the US dollar in global forex markets.
Scenario 1 – USD strengthens:
The global FX markets at some stage this year will start to price-in the ending of the Federal Reserve’s monetary stimulus (the ending of money printing) and the USD value will lift against all currencies as US short-term interest rates will eventually increase.
Under this scenario the NZD/USD exchange rate falls into the 70’s, which in turn pushes up inflation (imported goods) and GDP growth (export industry investment and jobs).
As a result of the currency depreciation, monetary conditions in the economy become far too loose and the RBNZ are forced to lift the OCR.
Scenario 2 – USD stays stable/weakens:
Nothing changes with NZ monetary conditions as the NZD/USD exchange rate stays in the 80’s, inflation remains low and GDP growth underperforms with a struggling export sector.
Even if the residential property market becomes hotter and credit growth gets out of hand the RBNZ response will be to threaten the banks with the macro-prudential measures instead of increasing the OCR.
No matter which way you look at it the exchange rate will continue to play a significant role in determining both inflation and economic growth outcomes.
Outside of commodity price movements, the value of the USD itself will be the largest factor in driving where the NZ dollar travels from its current lofty heights.
While the Kiwi dollar exchange rate will be crucial in delivering short-term interest rate movements, the longer-term swap rates will still follow US 10-year Treasury Bond yields.
Given the improved US economic outlook (outside fiscal hand-brakes) those long-dated US yields can only be stable to higher from here.
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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com