Raising savings is the best way to sustainably take pressure off the exchange rate, says Reserve Bank assistant governor John McDermott.
In a speech to Federated Farmers in Wellington today McDermott said the New Zealand dollar was overvalued.
The real effective exchange rate, which reflects not only the nominal rate but relative inflation rates with trading partners, is nearly 20 per cent above its average over the past 40 years.
The persistent gap between savings and investment was a "prominent" part of the explanation, McDermott said.
"Over the past 40 years New Zealand has demanded more capital for investment in housing, infrastructure and other assets than its domestic saving rate could finance," he said.
"This has meant an on-going reliance on foreign saving and capital inflows.
This saving shortfall has also put upward pressure on interest rates and the exchange rate ... resulting in a tradables sector that is smaller than desirable."
The solution to a high and variable exchange rate was not higher inflation, McDermott said.
"International and historical experience has shown that if a central bank runs monetary policy looser than is required it will generate inflation. Such future inflationary problems would be very costly to resolve in terms of growth and employment."
Intervening directly in the foreign exchange market was unlikely to sustainably lower the exchange rate.
"This is because daily foreign currency transactions in New Zealand dollars swamp any practical intervention capacity, averaging around $100 billion per day ."
And the greater the scale of intervention the greater the financial risk to the taxpayer.
The Reserve Bank had opted to use macro-prudential policy, in particular loan-to-value ratio limits, to help moderate risks in the housing market in part because it reduced the need to raise interest rates and so put pressure on the exchange rate.
But New Zealand's reliance on foreign savings to finance consumption and investment meant we had persistently needed interest rates above those in most developed countries,' McDermott said.
"Addressing the residential investment needs of a growing population and increasing the incentives for private sector savings, such as the tax treatment of investment income and issues around the long-term design of public and private pension systems, are the sorts of issues that need to be debated ."
To address the overvalued exchange rate the underlying economic imbalances had to be addressed.
"Raising domestic savings relative to our investment needs appears the best way to sustainably lower New Zealand's real interest rates and take the pressure off the real exchange rate."
Other areas of economic policy could reduce the harmful effects of exchange rate cycles, McDermott said.
Policy which increased the responsiveness of the building industry to housing demand would be the kind of micro-economic reform which, by making the economy more flexible, reduced the need for the exchange rate to carry the burden of absorbing economic shocks.
Refraining from tax cuts or increases in public spending in periods when the economy's resources were already stretched would reduce the pressure the Reserve Bank had to lean against.