Roger J Kerr wonders how Graeme Wheeler can call the NZD 'unjustifiably high' when it is now back to the levels they were targeting

By Roger J Kerr

By taking a calculated gamble that a lower exchange rate value is more important for the economy at this point in time than controlling inflation, the RBNZ may have potentially dug themselves into hole that could be messy to get out of.

The decision by the RBNZ last week in the OCR review to introduce the possibility of interest rate cuts as well as increases changed the monetary policy settings from a bias to increases to a “neutral” stance.

The statement was more dovish than expected with a new inflation forecast that predicts the annual rate to stay at or below 1% for the whole of 2015.

The looks to be a very brave call indeed.

The RBNZ obviously see the low oil prices offsetting the currency depreciation in respect to price trends in the economy over coming months. While the current tradable inflation rate is negative, the substantial depreciation of the NZ dollar against the US dollar over the last six months from 0.8800 to 0.7260 must inevitably lead to significant price increases on imported consumer goods as the currency hedging runs off.

There are signs already of retailers increasing prices due to the currency changes.

If inflation starts to move back up over the next six months due to the currency impact and the housing market remains buoyant, the RBNZ may find themselves having to revet back to the monetary tightening bias.

The current RBNZ forecast for the exchange rate on an overall Trade Weighted Index (TWI) over the next two years is 75, precisely where the TWI has reduced to over recent weeks.

Therefore, it is somewhat strange that the RBNZ continue to call the exchange rate unjustifiably and unsustainably too high!

The wording of the OCR review statement seemed designed to dissuade foreign investors from buying the Kiwi dollar at a time interest rates are being slashed all over the world and New Zealand increased theirs four times in mid-2014.

Interest rate cuts in New Zealand could be justified this year if the economy was slowing up abruptly and both households and businesses were in need to lower debt servicing costs as economic conditions become tough for them.

However the current state of the economy is completely opposite to that scenario and is fact one of 3% robust growth with the only real risk being agricultural production being hurt by a lack of rain.

Climatic conditions can change as rapidly as currency and oil prices; therefore it is a long bow to draw to say that strong economic expansion in New Zealand no longer leads to price increases.

High capacity utilisation in the manufacturing sector and the prospect of a tighter labour market causing delayed wage increases also point to upward price pressures going forward.

Should the Reserve Bank of Australia reject market pricing and not cut their OCR this week, the spotlight will come back on to the RBNZ as to appropriateness of their latest monetary policy position.  

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