The Reserve Bank is prepared to "scale up" its currency intervention if it sees opportunities to have a greater influence in the value of the Kiwi dollar, governor Graeme Wheeler said today.
The governor also said, if housing price pressures abated, there might actually be a possibility of lowering official interest rates.
In a speech to the Auckland Institute of Directors he reaffirmed that the RBNZ had been intervening in the currency markets due to concern about the high value of the Kiwi dollar. The value of the Kiwi dollar dropped by about US0.4c to around US80.9c in reaction to Wheeler's comments.
Wheeler first confirmed that the RBNZ had been intervening in the currency markets when appearing before a Parliamentary select committee earlier this month. Wheeler's comments today have come ahead of the release by the central bank this afternoon of figures for April that will indicate what level of intervention there has been in the currency markets.
Additionally, the RBNZ has been working on new "macro-prudential tools" as additional instruments to help promote financial stability. A deal between Finance Minister Bill English and Wheeler has cleared the way for the central bank to use so-called macro-prudential tools, if it chooses to, on a temporary basis to dampen excessive growth in credit and asset prices and strengthen the financial system.
Economists said today that the tone of Wheeler's speech indicated the RBNZ was keen to try out its new macro-prudential tools sooner rather than later.
Wheeler said the Reserve Bank has been responding to the rising exchange rate through two avenues: in maintaining the Official Cash Rate (OCR) at an historically low level [2.5%]l; and through a degree of currency intervention.
“The downward pressure on inflation exerted by the high exchange rate means that the OCR can be set at a lower level than would otherwise be the case.
"In recent months we have undertaken foreign exchange transactions to try and dampen some of the spikes in the exchange rate," he said.
“But we are also realistic. We can only hope to smooth the peaks off the exchange rate and diminish investor perceptions that the New Zealand dollar is a one-way bet, rather than attempt to influence the trend level of the Kiwi. We are prepared to scale up our foreign exchange activities if we see opportunities to have greater influence.”
Risks to stability
Wheeler said that the Bank is also concerned about the financial stability risks associated with the housing market, in particular the scale of housing lending, and especially high loan-to-value ratio (LVR) lending.
He said a strong run-up in housing markets can be a risk to future financial stability because it can increase both the risk of a sharp correction and the consequent financial sector disruption.
"The Reserve Bank is concerned that the current escalation of house prices is increasing the probability and potential effect of a significant downward house price adjustment that could result from a future economic or financial shock. These concerns are shared by the OECD and by the IMF in its recent review of the New Zealand economy, and housing risks have been noted recently by all three of the major international credit rating agencies.
“...Risks associated with excessive housing demand could normally be constrained by raising official interest rates and letting them feed through into higher mortgage costs. However, this would carry significant risks of a further strengthening in the exchange rate and further downward pressure on tradable goods prices. This might, in turn, be expected to push CPI inflation further below the 1% to 3% target range.
“This is where macro-prudential policies can play a useful role in promoting financial stability. Capital and liquidity overlays can help build up buffers in the banking system while adding to the cost of bank funding. And loan-to-value restrictions may help to reduce the actual supply of mortgage lending.
“If house price pressures abated, it would increase the possibility that the OCR could remain at its current level for longer than through this year. Similarly, if housing pressures are much less of a concern and the exchange rate continues to appreciate and the inflation risk looks low, it may create opportunities to lower the OCR,” Mr Wheeler said.
“Macro-prudential measures can be useful in helping to restrain housing pressures, but they are no panacea. This reinforces the importance of measures to enhance productivity in the construction sector, free up land supply, and examine related tax issues.”
He reiterated the warning first issued by deputy governor Grant Spencer last month that if the house price and credit expansion begin to fuel excessive consumption spending and inflationary pressures, a monetary policy response would become more likely - namely higher interest rates.
Wheeler said that the exchange rate and the housing market present difficult challenges for monetary policy when both the currency and asset prices appear to be overvalued and investor demand is expected to remain strong.
“New Zealand’s exchange rate is significantly overvalued. Fortunately it has retreated a little in recent weeks with a stronger US dollar.
“However, investors seem undeterred by the fact that our exchange rate is over-valued, the current account deficit is sizeable and private sector external indebtedness is high. For the current exchange rate to be sustainable in the long term, sizeable increases in the terms of trade and/or productivity would be needed. “Investors also appear to downplay the liquidity risks inherent in a small market like New Zealand.
"This is reflected in our past exchange rate cycles that have exhibited substantial overshooting followed by sharp and rapid exchange rate depreciation."