Equipping the Reserve Bank with new tools could weaken the link between interest and exchange rates, allowing it to fulfil its inflation-targeting role with less collateral damage to the export sector, says New Zealand Institute of Economic Research economist Kirdan Lees.

In a note prompted by the impending conclusion of a new policy targets agreement between the Government and incoming governor Graeme Wheeler, Lees, a former Reserve Bank economist, argues that the current Policy Targets Agreement (PTA) has too many targets for only one policy lever, the official cash rate.

The housing boom in the mid-2000s showed interest rates alone cannot achieve multiple goals, he said.

But "macro-prudential" tools the bank has been working on provide other means of dampening credit cycles without attracting inflows of foreign capital in the way higher interest rates are liable to do.


The most effective, Lees suggests, is likely to be varying the core funding ratio - the proportion of banks' funding they are required to get from depositors and long-term wholesale sources rather than the short-term credit markets, which froze during the global financial crisis.

The Reserve Bank instituted a core funding ratio primarily to strengthen the resilience of the banking system.

But raising the ratio increases the banks' cost of funds. It means the official cash rate does not have to work as hard to deliver a given level of mortgage and business lending rates, keeping the OCR and wholesale interest rates lower.

That reduces the attractiveness to international investors of parking funds in New Zealand and thereby relieves pressure on the exchange rate.

Other macro-prudential tools under consideration include regulating loan-to-value ratios for mortgage loans, and requiring banks to maintain counter-cyclical capital buffers.

Concern that the monetary policy framework regularly delivers an overvalued exchange rate is longstanding and currently well-founded, Lees says, citing work by US economists William Cline and John Williamson. That has placed New Zealand among the top three overvalued currencies, among 34 they look at, in each of the past three years.

"Right now the exchange rate is high for both fundamental reasons (New Zealand's economy is outperforming advanced economies like the US) and non-fundamental reasons (governments buying New Zealand dollars to sit in foreign reserves rather than investing in the real economy)."

Macro-prudential tools could limit exchange rate movements that are not based on fundamentals.

"There is currently a risk that some future government will succumb to the clamour to 'do something' about the high exchange rate, and ends up doing something silly," Lees said.

"The introduction of macro-prudential tools gives an opportunity to soften the link between the interest and exchange rates by being able to target financial asset bubbles directly."