RBNZ says Kiwi surge overdone, markets missed downside risks

by NZ Adviser12 Aug 2016
(Bloomberg) -- New Zealand’s central bank said markets missed the downside risks to the outlook for interest rates presented in Thursday’s policy document and got ahead of themselves in driving the currency to a one-year high.

The Reserve Bank highlighted two alternative scenarios in its monetary policy statement and both of them were on downside risks to rates, Assistant Governor John McDermott said in an interview late yesterday in Wellington.

“I think the market should have picked up this signal,” he said. “Usually we have one upside and one downside. That would have been very artificial in the current environment. We put two downside scenarios, and to make sure we got the attention we think they deserve, we promoted them from chapter five to chapter two.”

The New Zealand dollar surged 1 percent after the RBNZ cut its benchmark rate by a quarter point to 2 percent, a fresh record low. Some investors had been looking for a more aggressive easing signal from the central bank, which indicated it would cut rates at least once more to boost weak inflation.

The jump in the exchange rate was a “funny reaction” to a rate cut, said McDermott. 

“Let’s see if it stays a week. You don’t set monetary policy on a single day’s event. But if it’s persistent” and “if we think it’s because of the weak world delivering this, then the appropriate response that we’ve communicated is that we would lower interest rates.”

After spiking to 73.41 U.S. cents immediately after Thursday’s rate decision, the kiwi retreated to 72.09 cents at 9 a.m. in Wellington Friday, little changed from its position before the policy announcement. It is still up almost 8 percent since the end of May.

While the RBNZ doesn’t target the exchange rate, the longer it stays elevated, the more it damps tradable inflation and makes it harder for the central bank to meet its mandate, McDermott said. “The more that happens, it means monetary policy would have to do even more work to compensate that particular headwind.”

The RBNZ’s latest projections assume the currency’s trade weighted index will fall gradually as global economic conditions improve and overseas interest rates rise. In an alternative scenario where the index remains at its current elevated level, the central bank projects it would need to cut interest rates much further, with the official cash rate potentially falling below 1 percent.

Inflation Expectations
A second alternative scenario looks at the possibility of a significant fall in inflation expectations, which would also require rates to go a lot lower than current projections.

“Inflation expectations are a very slow-moving beast, but once they’ve gone too far down we would have a tremendously difficult job fixing them,” said McDermott. “That’s the issue, and that’s why we’ve moved” rates and their future path, he said.

Thursday’s rate cut was just the second this year, but McDermott rejected the notion that the RBNZ is a “reluctant cutter,” saying it has to balance all the risks in the economy.

Financial stability risks around the current housing boom were well understood, he said, adding: “which central bank would feel that it had to rush things when it already had a growth rate profile of 3.5 percent?”

“The economy is growing quite well, so you don’t want to overdo it,” McDermott said. “You spend all your bullets now when you’re growing well, what happens if something really bad happens? But of course if the world turns out to be weaker, pushing the exchange rate to an even more elevated level because of that, the right thing to do is to lean against that with monetary policy.”

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