Brian Fallow

The Economics Editor of the NZ Herald

IMF cautions against tinkering

NZ's monetary framework should stay despite overvalued kiwi, says international team after annual check-up.

Using macro-prudential tools to control the high dollar would need to be done with caution, says the IMF. Photo / Thinkstock
Using macro-prudential tools to control the high dollar would need to be done with caution, says the IMF. Photo / Thinkstock

The International Monetary Fund counsels against "messing with" the monetary policy framework just because the Kiwi dollar is temporarily overvalued.

"We strongly feel the framework for monetary policy, including a flexible exchange rate, has been one of the reasons New Zealand is in a relatively resilient position, compared with some other countries," Bruce Aitken, who headed the IMF team which has been giving the economy its annual check-up over the past two weeks, said yesterday.

"Do you want to mess [with] the framework because the exchange rate at the moment is overvalued, and do potentially long-term damage? I would be very reluctant to go down that path."

Aitken estimated the dollar was overvalued by about 15 per cent, "though it is difficult to put a precise figure on it" .

It was likely to remain high as long as global monetary policy stayed very loose, he said, and how long that would be depended on recovery in the United States and, more problematically, in Europe.

"It won't be the next year or two, but there's a lot of uncertainty about it," he said.

Among the factors underpinning the exchange rate are the difference between New Zealand and foreign interest rates and portfolio capital flows as foreign investors diversify their holdings.

Asked if that included other central banks and sovereign wealth funds, Aitken said he would not be surprised if it did.

But unlike several countries, New Zealand's central bank had scope to cut interest rates if it were sideswiped by another major shock, and that should be the first line of defence before departing from a path of fiscal consolidation.

"As evident during the global financial crisis, the free-floating New Zealand dollar provides an additional cushion against external shocks, including disruptions to offshore funding and negative terms of trade shocks, with widespread hedging by banks and businesses insulating their balance sheets from fluctuations in the exchange rate," the IMF's statement, released overnight, said.

The fiscal discipline imposed by the Government's commitment to returning to surplus allowed the Reserve Bank to keep interest rates lower for longer, reducing pressure on the exchange rate.

The IMF expected economic growth to pick up this year but that was subject to risks "with an increase in construction activity offsetting headwinds from budget deficit reduction, the strong dollar and the possibly protracted impacts of a severe drought".

Another risk was the rise in house price inflation, particularly in Auckland, with supply bottlenecks and high prices "by most measures of affordability".

"In these circumstances there is an emerging risk that sustained rapid price growth could give rise to expectations-driven, self-reinforcing demand dynamics and price overshooting," it said. "A shock to household incomes or to borrowing costs could cause a sudden price correction, reducing consumer confidence, worsening banks' balance sheets, and impacting overall economic activity."

The IMF backed moves to equip the Reserve Bank with macro-prudential tools to fight a build-up of systemic risk from rapid house-price inflation and credit growth.

But Aitken said there was not a lot of experience of the use of such measures in advanced economies.

They should be used infrequently and with caution, and not be seen as a routine management tool, he said.

"You would want to put them in place early in the cycle but if they were in place for a long time they would probably be circumvented.

"The fund's view is they should be deployed in a timely way, not very often and not for very long, and not seen as a substitute for the official cash rate."

- NZ Herald

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