Big swings in interest rates would be the price we paid if the Reserve Bank were to aim for exchange rate stability, Governor Alan Bollard says.
He appeared yesterday before Parliament's finance and expenditure select committee, which is conducting an inquiry into the monetary policy framework.
Bollard defended the overall framework, saying that over the past 10 years, inflation had averaged about 2.5 per cent and economic growth around 3 per cent, while unemployment had halved.
New Zealand was one of a number of countries which had enjoyed reasonable growth and reasonable price stability but increasing exchange rate instability, he said.
The bank had looked closely at what other small economies like Singapore and Chile did but found no model that would work here.
"We have also modelled what would happen if we were to focus on the exchange rate via monetary policy and use that as the stabilising influence. The answer is you have to move the interest rate around by massive amounts to do that."
Rodney Jones, former managing director of Soros Fund Management in Hong Kong who now advises British and American hedge funds on Asian economic developments, agreed that the Singaporean model was not a viable alternative for New Zealand.
Over the past 30 years, Singaporean authorities had maintained price stability while managing their dollar tightly. But it had at times required aggressively tight fiscal policy, and was now, in any case, coming under intense pressure from the same globalised capital that the New Zealand model was grappling with.
Last year, the Monetary Authority of Singapore had had to accumulate the equivalent of 44 per cent of its GDP in foreign exchange, Jones said.
"They are having the same sort of debates, but behind closed doors," he told the MPs.
Likewise, Hong Kong's peg to the United States dollar had sometimes required big adjustments in assets prices, like a 65 per cent fall in the property market between 1997 and 2003. Such a thing was not sustainable in a democracy.
Bollard said some small countries had dealt with the issue by going into a currency union like the European Union's.
"We don't have that option. Australia has exactly the same problems with the exchange rate that we have."
The bank's deputy governor, Grant Spencer, said a fixed exchange rate could potentially facilitate trade by reducing exchange rate volatility.
"But on the other side it takes away our independence in terms of running an independent monetary policy and it takes away the exchange rate as a buffer against shocks that are specific to New Zealand. And we see quite a few of those."
Bollard said it would be interesting to know what conditions would be like if the Reserve Bank did nothing at all. "It is quite conceivable - if there was such a thing as a free market setting all that - that we might have rates pretty much where they are."
That was because New Zealand households had been very keen to borrow and at quite high rates.
There had been a glut of liquidity internationally and foreign savers had been happy to lend. "That's one of the things that has been determining the exchange rate," Bollard said. "We've been the meat in the sandwich."