The exchange rate is still too high given current economic conditions, especially commodity prices, Reserve Bank governor Graeme Wheeler says.

In a speech to ExportNZ in Tauranga this morning he also explained why he expects inflation to return to 2 per cent in the first half of next year, why he rejects calls for aggressive cuts to interest rates from here (though some further easing is likely), and why interest rates are an inappropriate tool for dealing to runaway house price inflation in Auckland's.

On a trade-weighted basis the New Zealand dollar has fallen 14 per cent since mid-April, including 5 per cent since the Reserve Bank started cutting the official cash rate last month.

"Our models suggest that the real exchange rate is currently in the vicinity of its long-run equilibrium value - if growth, inflation, and the terms of trade were at their long-run trends.," Wheeler said.

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But they are not. The central bank believes growth is running close to its potential or sustainable rate of around 2.5 per cent, but inflation at 0.3 per cent is well below -- 2.1 percentage points below - its long-run trend, while the terms of trade are being dragged lower by plunging dairy prices and the bank sees the potential for worse to come on that front..

At the kiwi dollar's current level the country is heading for deeper balance of payments deficits over the next two years and a mounting level of external debt.

As for inflation persistently falling below the 2 per cent target mid-point, and below the bank's forecasts, Wheeler pointed out nearly half the consumers price index consists of tradables prices and they account for three-quarters of the deviation of the inflation rate from its long-term trend.
Low inflation is the norm in a world economy with excess capacity, subdued wage growth, falling commodity prices and interest rates at historic lows.

Even so, Wheeler expects inflation in New Zealand to be close to 2 per cent by the first half of next year as the dollar's decline flows through to higher price for imported goods and last year's halving of world oil prices drops out of the annual number.

"Our modelling suggests that a 1 per cent exchange rate depreciation boosts annual CPI inflation, albeit with a considerable lag, by around 0.1 percentage points."

But the speed of that pass-through would depend on firms' currency hedging and pricing power, and on the strength of net immigration with its moderating effect on wages.

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In what appears to be a reference to Westpac economists' forecast that the official cash rate will need to fall another full percentage point to an all-time low of 2 per cent, Wheeler said, "Some local commentators have predicted large declines in interest rates over coming months that could only be consistent with the economy moving into recession."

But at this point the Reserve Bank considers that while economic growth might be a little below trend, there were several factors supporting it including easing monetary conditions, high net immigration, ongoing growth in construction and continued strength in the services sector.
Wheeler said he was conscious of the risk of lower interest rates exacerbating the already extensive housing pressures in Auckland.

"Raising interest rates can be a useful policy response in leaning against asset price pressures when they are widely based and wealth effects are spilling over into demand and triggering broader inflationary pressures," he said.

But there was currently little evidence of that. "And in the present situation, raising interest rates would be inappropriate as it would put upward pressure on the exchange rate and further dampen inflation."

Read the speech here: