A hypothetical chat – exchange rate overvaluation

By Matt Nolan 28/01/2013

With people in NZ constantly yelling about the dollar, and yelling at the Reserve Bank, I thought I would host a hypothetical discussion that hopefully helps to explain the issues – and why inflation targeting isn’t the cause of any of the perceived problems.  Here it goes:

Intelligent non-economist (INE):  The dollar is too high, and its destroying New Zealand’s economy.

Nolan (N):  Rightio, why.

INE:  When the dollar is too high, productive industries don’t have an incentive to produce or be here, so it hollows out the country.

N:  The dollar is a relative price.  If the price is too high, we need to ask why it is too high – and we need to take into account what other countries are doing.

INE:  Exactly.  Other countries are devaluing their currency and we are not because we are obsessed with inflation targeting.

N:  Not really.  Other countries are setting monentary policy to reach their inflation mandate, and so are we.  With a whole bunch of countries all targeting inflation outcomes of “2%”, and setting monetary conditions appropriately, this isn’t the cause of any big disjoint in the dollar from its “fundamental value” (unless you believe the RBNZ is setting policy too tight, or other economies are setting it too loosely, for their mandate – which would imply low inflation here, or high inflation overseas).

INE:  But you are missing the point.  It is obvious that the RBNZ is setting an interest rate that is too high for the economy, just to meet its inflation mandate!

N:  This is where I think you are a bit confused on what the RBNZ is doing.  By meeting its inflation mandate, it is partially setting the opportunity cost for bank lending (the OCR), which helps to guide the interest rate towards its fundamental level.  However, the fundamental interest rate isn’t set by the Reserve Bank, it depends on savings and investment in the economy, the expected rate of return, the time preference of individuals, the stance of fiscal policy, and the structure of the tax system (and its impact on rates of return).  If non-inflation accelerating real interest rates in NZ are higher it has nothing to do with the Reserve Bank – and it has everything to do with these issues, which are influenced by government policy, industrial policy, competition policy, and the efficiency of financial markets.

INE:  But, the Reserve Bank sets interest rates and the exchange rate!

N:  Not really.  They are “managing our fiat currency” in such a way that the real value of a dollar erodes at a constant and predictable rate – this increases certainty for households and businesses, and helps them interpret what changes in market prices mean.  They also try to limit the variability output in the general economy in the short term, by taking advantage of aspects such as “money illusion” through the way they change the OCR (although, things get a bit more complicated as we add in expectations and time consistency – these things can be left to the side for now :) ).  However, none of this has to do with any long-term, persistent, shifts in the New Zealand economy.  In so far as we are concerned about the exchange rate being “too high” for a long period of time, and the current account deficit being “persistently large”, this is the result of the fundamental savings-investment issues in the New Zealand economy.

INE:  But if the RBNZ cut the OCR, and interest rates fell, and the dollar fell, we’d be “more competitive”.

N:  Then prices, including costs, would rise.  Within a few years, our exporters would be just as uncompetitive at the new “lower” exchange rate – implying that these persistent imbalances would simply return.

INE:  But exporters are complaining about the exchange rate.

N:  Exporters are complaining about the low rate of return – the exchange rate is a symptom of this not the cause.

INE:  So you are saying that these issues have nothing to do with inflation targeting, and even the impact of the exchange rate itself tends to be overstated.

N:  Yes.

INE:  I don’t believe you.

N:  That’s a pity.