There are no simple solutions available to the Reserve Bank to deal with a New Zealand dollar that is significantly overvalued, says governor Graeme Wheeler.
In a speech in Auckland yesterday to the Manufacturers and Exporters Association, which has been very critical of the bank on this score, he traversed options which had been proposed and their drawbacks.
Cutting the official cash rate is something the Reserve Bank of Australia has done over the past two years, by 175 basis points so far, but it has not moved its exchange rate.
"The relationship between the OCR and the exchange rate isn't a simple one. Lower interest rates can reduce pressure on the exchange rate but analysis of past OCR cuts in New Zealand shows a relatively weak statistical relationship," Wheeler said.
"Any adjustment to the OCR needs to be credible to the market. Lowering the OCR in a one-off manner that's inconsistent with the Policy Targets Agreement could lead to expectations of a subsequent reversal."
And lowering the OCR on a sustained basis in a manner inconsistent with the PTA would result in higher inflation and a weaker exchange rate.
"Eventually inflation would increase costs and erode competitiveness, and lead to expectations of higher inflation."
Sacrifices to future growth would eventually be needed to cure the inflation problem.
Intervening directly in the foreign exchange market was something the bank would do, Wheeler said, "when circumstances are right".
"We want investors to know that the kiwi is not a one-way bet."
But the bank's policy is to intervene only when it would make a difference.
Right now the markets are dominated by the spillover effects of massive quantitative easing (QE) - more than US$5 trillion worth - by countries worst hit by the global financial crisis.
"Given the strength of recent capital flows, we can only attempt to smooth the peaks of the USD/NZD exchange rate; we cannot determine the level."
The New Zealand dollar fell around half a cent against the US dollar on the headlines that the bank is prepared to intervene.
"But this was no more than a restatement of the Reserve Bank's policy on intervention, which has been in place since 2003," said Westpac economist Michael Gordon.
Wheeler also ruled out quantitative easing or printing money here.
New Zealand did not experience the kind of severe economic damage suffered by countries that had resorted to QE, Wheeler said.
"Quantitative easing, together with its precursor of very low interest rates, is not justified in the New Zealand situation. Our economic challenges are different from the US, the euro area, and Japan, and quantitative easing would increase inflation, raise inflation expectations, stimulate asset prices, and lead eventually to higher interest rates."
Trying to cap the New Zealand dollar in the Swiss manner would also amount to QE on a massive scale and be highly inflationary, he said.
As for broadening the Reserve Bank's objectives, it is already required under the PTA to look at activity as well as inflation and seek to avoid unnecessary instability in output. The economy faced an overvalued exchange rate and an overheating housing market, especially in Auckland, Wheeler said.
Macro-prudential tools being developed to address the latter "could be helpful in alleviating pressure on the exchange rate at the margin".
Gordon said the central bank had been escalating its public expressions of concern about the housing market.
"But this is the first time it has been described as 'overheating' - reinforcing the message that monitoring asset prices and risks to banking stability are now a major part of the Reserve Bank's mandate," he said.
"There is a good chance that macro-prudential tools will be deployed at some point in this cycle, though it's more likely to be from next year onward."
Greens co-leader Russel Norman said the governor appeared to be trapped in a time warp from the 1980s. "Shoulder pads have had their day, and so has targeting monetary policy solely at inflation."