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Treasury Report: Exchange Rate Developments and Implications

Published 18 Feb 2003

This report was prepared for the Minister of Finance, Hon Dr Michael Cullen on 5 February 2003 and is available below. 

Treasury Report: Exchange Rate Developments and Implications

Executive Summary

The New Zealand dollar has appreciated rapidly over the past year, particularly against the US dollar. Underlying this appreciation is an economy that has enjoyed a period of relatively strong and stable growth, which has been associated with interest rates that are high relative to other countries. Other important factors include a weakening of the US dollar and a substantial reduction in New Zealand's current account deficit.

The economy may grow more slowly than expected over the coming year if the TWI continues to appreciate at a similar pace. In the DEFU, real GDP growth was forecast to slow from over 4% in 2002/03 to a still robust 2.5% in 2003/04. The recent appreciation of the exchange rate, if maintained, could act to slow growth further. Just how big the impact of recent developments is depends on a number of factors including:

  • the extent and duration of the period the exchange rate spends at or above its current level;
  • the reaction of monetary policy;
  • the extent of hedging undertaken by firms;
  • the response of firms in terms of their investment, pricing and employment decisions; and
  • the response of households to lower inflation and possibly lower interest rates.

Some of these factors will act to reduce GDP growth while others could boost growth. Overall, our preliminary modelling suggests that recent developments could be mildly negative for real GDP growth over 2003/04. However, tentative signs that the economy may be carrying more momentum into 2003 than we forecast means that any moderation in growth may occur from a higher starting point.

The Reserve Bank's policy is to look through the direct price level effects of the appreciation and focus predominately on the demand and medium-term inflationary effects of exchange rate movements. This helps to reduce the volatility of output and interest rates but at the expense of somewhat more inflation variability. Attempting to use interest rates to influence the level or direction of the exchange rate regardless of the inflationary consequences of doing so risks allowing inflation to move outside the target range. If this leads to higher inflation expectations a period of prolonged monetary tightness may be required to bring expectations back to a level consistent with the medium-term inflation target of 1 to 3 percent.

Fiscal policy that works in the same direction as monetary policy can help to mitigate the extent of the rise in the exchange rate. Present monetary policy settings are appropriate given an expected slowdown in growth and a moderation of inflation. This suggests that current fiscal policy settings remain appropriate. An unanticipated easing of fiscal policy could weaken or reverse the anticipated effects of monetary policy and put renewed pressure on interest rates and the exchange rate to rise.

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