Calls to cut cash rate misguided

Calls for the Reserve Bank to cut the official cash rate in hopes of bringing the exchange rate down are misguided, a Westpac economist says.

Lowering the OCR might not reduce the exchange rate and could make the economy's structural weaknesses worse.

"The exchange rate is a pretty hard thing to steer," said Westpac economist Sharon Zollner.

"The foreign exchange market is a whole lot of people trying to guess what a whole lot of other people are going to do."

Over the long term there is a reasonably good correlation between interest rate differentials and the exchange rate. But it is longer-term interest rates that matter, not the OCR, which is an overnight rate.

The relationship is stronger for the trade-weighted index as a whole than for the cross rate with the United States dollar.

"There have been numerous episodes in New Zealand's recent history when the exchange rate and interest rate differentials have moved in opposite directions," Zollner said.

For example when investors lose their appetite for risk, as in the Asian crisis, and the sub-prime crisis, the currency will tend to drop regardless of where interest rates are set.

When global risk appetite returns, as it has now, commodity prices tend to rise and so does the currency.

The exchange rate is high compared with the last two recessions, making an export-led recovery harder.

"[But] we struggle to say whether the currency is under- or over-valued at present."

On a trade-weighted basis it is only slightly above its average level since 1995 even though the terms of trade (export prices relative to import prices) are 14 per cent above their average over the same period and the New Zealand economy has come through the global recession better than most.

Zollner accepts that some of the strength of the kiwi and aussie is as proxies for a trade the market might like to do but cannot: short the US dollar and long the Chinese renminbi.

But if they turned out to be poor proxies investors betting that way would lose money, she said.

Much of the desire for a lower currency is to correct the economy's structural imbalances: heavy reliance on foreigners' savings and growth dominated by debt-financed consumption rather than exports.

However lower interest rates would be more likely to make those imbalances worse than better, Zollner argues.

Westpac would "not be at all surprised" if the exchange rate moved lower over the next two or three months as part of a general retreat from the prevailing level of optimism in global financial markets.