The Kiwi dollar is now some 8% (trade weighted basis) below its December 2005 peak, or 11% down on its March 05 peak against the US dollar. On either measure, it has run out of puff. In terms of assessing what this signifies, the starting point is to form a view on why it has lost steam.
There are a number of candidates;
Our burgeoning balance of payments deficit has finally caught up with the currency and the sheer size of the demand for foreign exchange by our importers dwarfs that for NZ dollars by our exporters remitting their offshore winnings, that it’s driven the price of foreign currency up in NZ dollar terms.
The recent pause in interest rate rises in New Zealand contrasts with the ongoing step rate rises in the US meaning that investors can get a relatively better rate elsewhere than was the case when our Reserve Bank was ramping rates upward.
The prospect of at least a growth recession and possibly a proper recession in New Zealand is discouraging offshore investors.
The “bad news” broadcasts about New Zealand’s economy to the world by our own officials and by many a commentator have finally spooked foreign investors.
There are elements of all of the above in recent events with arguably the shrinking interest rate gap between here and overseas being the most recent addition to the factors weighing against our dollar. Up until December it was our rapidly rising interest rates that kept oopah in our dollar. Yet only the US has raised rates since our last rate rise on December 8th. Admittedly though there is at least one more rise in prospect there and as well in Australia the next move is expected to be up as well.
So as much as anything it’s the expectation that rates will be rising elsewhere but no longer here, that’s taken the wind our of our interest rate-fueled currency.
The next question then is whether the outlook for our interest rates is for them to remain steady or to drop and why. Certainly since January our market-determined short rates have dropped about 0.15% as traders have concluded the Reserve Bank has finished with rate rises, although there is yet to form an expectation as reflected in this market that rates are to fall. Our 3 year to 10 year bond rates remain well below our short rates as they have for yonks. So the bond market anyway sees lower interest rates ahead, whether due to lower inflation, an economy in recession or both can’t be said. The bond market has seen this though since mid-2004 and has been wrong so far. Arguably, the fall in our bond rates has simply paralleled the rise in our currency which took off from that time in line with our Reserve Bank’s campaign of interest rate hikes.
How to bring these interest market developments together!
Our central bank anticipated unacceptable inflation in mid-2004 and has been raising rates ever since. Offshore investors responded by buying our bonds and sending those rates south substantially. Since then our economy has hit full capacity, inflation has exceeded its permitted ceiling and parts of the economy have stalled under the exchange rate/interest rate strain. Exports of course have been at the vanguard of the retreat, although more recently the consumer has shown tentative signs of pulling back. Their withdrawal is very tentative however, with the higher ticket items of cars and houses bearing the brunt. House prices remain in denial.
What appears to be emerging is a period of stagflation for New Zealand – where the economy’s growth rate comes off, thanks to slugged exports and a mild pullback in consumer demand – but where price pressures remain unacceptably high due to ongoing pressure on global resource prices, wage cost pressures here from a tight labour market, and now added to by a falling dollar.
How will it end? There are a number of candidates that could pull the economy from the mire. They include;
a strong rise in productivity, brought on by businesses acknowledging this is the only thing they can do to combat labour shortages and a rising cost of capital
a windfall gain on primary product prices as happened before and which ongoing strong world growth could underpin again
a migration upturn due to policy easing. Again this happened a couple of times through the 1990’s and was one of the two factors underpinning a strong housing market. It is not on the government’s agenda yet however.
The more likely scenario at this stage however is the muddle-through stagflation one, with no circuit breaker being obvious yet. Recent high rates of investment have yet to prove they are productivity-focused as opposed to being afforded by easy money. Politically inspired government spending on infrastructure for example, is notorious for demonstrating low efficiency of capital.
Raising interest rates certainly does curb inflation eventually but it can be a long hard grind with a definite cost to economic growth along the way, if there are no rabbit-from-the-hat factors such as the three above.
This muddle looks to be the New Zealand way for the next 12 months.
© Copyright; Foundation for Economic Growth and various authors. Individual authors retain their own copyright.
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