By Rodney Dickens*
Governor Wheeler has opened Pandora’s Box and some weird stuff came out.
The analysis in the March MPS was just what you would expect from the stereotypical economist.
On the one hand positive factors were discussed driving economic growth and on the other hand factors constraining growth were identified.
On the one hand upside risks to the RBNZ’s predictions were noted and on the other hand downside risks were discussed.
The contents of the March MPS suggest that Governor Wheeler is going to be pretty systematic and rigorous (that is, weigh up the pros and cons before acting). And in my assessment now is a time to be contemplative rather than make brash decisions about the OCR.
But the March MPS also contained a bit of weird stuff, like the following:
If the exchange rate rose for reasons not justified by New Zealand’s economic fundamentals, all other things equal, this would lead to a lower-than-expected OCR. (MPS, page 5).
This comment was reinforced in a special feature titled “The policy implications of persistent exchange rate strength” that contained the two charts below that quantified how much lower the track for the 90-day bank bill yield might be for a marginally higher track for the exchange rate, as measured by the NZ dollar trade-weighted exchange rate index or TWI.
The blue projection lines in the charts are the RBNZ’s central predictions, while the red lines represent the alternative “scenario”. The RBNZ doesn’t provide OCR forecasts, but the forecasts it provides for the 90-day bank bill yield are close proxies for OCR predictions.
Effectively Governor Wheeler has signalled that if the NZD remains elevated against currencies of our major trading partners in a way that isn’t justified by the economic fundamentals he will cut the OCR in the second half of the year.
The first somewhat disturbing thing about the RBNZ’s “scenario” predictions relates to the “justified by New Zealand’s economic fundamentals” comment.
There are two sides to any exchange rate and in the case of the NZD TWI, the NZD is on one side and on the other side are the USD, AUD, Euro, Yen and Pound. Consequently, the economic fundamentals relevant to the TWI are not just NZ fundamentals, but NZ fundamentals relative to those in the US, Australia, Eurozone, Japan and UK.
If you look at NZ economic growth prospects, aside from the drought that will have only a passing impact, and compare them to the combined prospects for the US, Australia, Eurozone, Japan and UK, it is probably justified to expect the NZD to remain high for some time if not even head higher.
The US, Eurozone and UK will face continued fiscal austerity for some time, Japan is a basket case in terms of the level of government debt, while Australia faces some challenges because the resource sector boom is running out of steam.
In a June 2009 Raving I looked at the impact of the financial crisis on the NZD and argued that it would head higher, much as it has done, while in earlier Ravings (here and here) I showed what economic fundamentals really drive the major cycles in the NZD/USD and NZD TWI.
The most important economic fundamental that I identified as driving the major cycles in the exchange rate largely justify the current levels of the NZD/USD and NZ TWI (i.e. NZ economic growth prospects look better than those of our trading partners).
In light of that I have been wondering whether the “scenario” presented in the March MPS was a gesture to show that Governor Wheeler cares about exporters and local producers competing against imports, but will have his hands tied by the economic fundamentals (that is, a continued high NZD TWI will be justified rather than not justified, so OCR cuts won’t be delivered).
Alternatively, the governor may plan to go down the road travelled by both Governor Bollard and Governor Brash, which is particularly concerning because in both cases it ended up being counter-productive.
Will the failed experiments of Governor Bollard and Governor Brash be repeated?
An experiment by Governor Brash in 1993 and another one by Governor Bollard in 2003 show how misguided the “scenario” predictions in the March MPS are. Hopefully this doesn’t mean that every 10 years the RBNZ is doomed to repeat the same mistake over and over.
In 1993 the NZD TWI started to increase ahead of when the RBNZ felt was justified and to a significant extent in response to this it drove down the 90-day bank bill yield (the first area highlighted in the next chart).
In that case the NZD TWI ended up sailing ever higher and the RBNZ ended up having to more than reverse the fall in the 90-day bank bill yield.
Well ahead of the RBNZ the forex market realised that NZ was heading for a period of strong economic growth, with the strong growth fuelled more by the interest rate cuts in 1993. The NZD TWI went higher despite lower interest rates because the most important economic fundamental driving it is relative economic growth (i.e. growth in NZ relative to growth overseas). And interest rates are the primary driver of economic cycles.
This is mainly because they are the most powerful driver of housing market cycles and the housing market is pivotal in economic growth cycles. The OCR only came into existence in early 1999 and prior to this the RBNZ focused on the 90-day bank bill yield as the most important interest rate.
In due course Governor Brash realised the mistake he made in 1993 and subsequently confessed to having made one.
Unfortunately, by the time 2003 came around the lessons learnt from Governor Brash’s experiment in 1993 had been lost by the RBNZ; lost or overlooked because Governor Bollard wanted to try what I termed his “go-for-growth” experiment.
The appreciating exchange rate probably didn’t play such a large part in driving the decision to cut the OCR in 2003 relative to what was the case in 1993, but in the wake of an appreciating NZD TWI Governor Bollard cut the OCR (the second highlighted area in the chart). And again the NZD TWI and subsequently interest rates ended up marching higher. The interest rate cuts again helped fuel the housing market and economic growth more generally, so from a forex market perspective it was like waving a red rag at a bull (i.e. rather than get the exchange rate down the interest rate cuts played a direct part in driving it higher via the boost to economic growth).
In the face of what was learnt in 1993 and again in 2003 it strikes me as bizarre that the March MPS showed signs of wanting to open Pandora’s Box yet again.
No amount of wishful thinking by the RBNZ or anyone else will mean interest rate cuts will deliver a lower exchange rate! Prime Minister David Lange was on the mark when he described forex dealers as “reef fish”. He probably called them this in a demeaning way because of their tendency to dart from place to place in a group. But it is also relevant in that reef fish live in hot, tropical waters and what forex traders are attracted to most is hot economies.
The spike in the NZD after the stronger than expected December quarter GDP number was released by Statistics New Zealand on 21 March is more evidence of this.
And nothing is more effective at warming up economic growth, for a temporary period at least, than interest rate cuts.
If you want to make business and/or investment decisions based on sound analysis rather than wishful thinking I recommend that you consider signing up for some of our pay to view reports, like those on the outlooks for house prices and related topics (see http://www.sra.co.nz/index.php/housing-prospects), residential building and related topics (see http://www.sra.co.nz/index.php/building-barometer), economic growth and interest rate prospects (see http://www.sra.co.nz/index.php/interesting-times), NZD/USD and exchange rate prospects more generally (see http://www.sra.co.nz/index.php/forex-prospects), and for critiquing the RBNZ’s forecasts (see http://www.sra.co.nz/index.php/forex-prospects).
*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.