Gareth Morgan, Director of Gareth Morgan Investments
Reserve Bank Governor Don Brash is defending the value of the currency as vigorously as any of his European counterparts have done in recent months. But will he fail, as most of them have done? Strong selling has continued despite his efforts, pushing the currency below his mandated minimum of 53 on the Trade Weighted Index, so he will have to tighten again. On the face of it, he can only win as he has a free mandate to manage the currency as he sees fit in the fight against inflation. Trouble is, the markets do not believe him when he says that the currency is too low. This morning he published an inflation forecast for 1993 of 0.8%, in the bottom half of the government’s target range. Within minutes, he was warning the markets that the target was at risk. One might ask, who was he trying to kid? With prices stable, many in the market expected easier money and a lower dollar. Instead, they got a near half percent rise in interest rates with more to come.
Recent events have disappointed a coteries of economists who had forecast a rising $NZ, while a further group have been advising that the Reserve Bank would give a warning of unacceptable inflation risks in it six monthly statement today. But no. It dropped its inflation forecasts and said it saw no significant risks to the outlook. The tightening was driven solely by a fall in the TWJ as market participants sensibly saw the statement as justifying a lower level. Thus the governor has placed himself against the markets, insisting, unsupported by his just-released analysis, that 0-2% inflation was at risk.
The Governor and his bank have always insisted they do not target any particular level of the exchange rate and in lip service to that vow, they do not intervene directly in the currency markets. That leaves interest rates as the sole mechanism for influencing the exchange rate. With it now misbehaving, the governor has only the blunt instrument of a rise in interest rates to achieve his hour-to-hour target for the exchange rate. But the currency markets are not playing ball. The usual cajoling and threats are not working. His credibility is at risk. He must win because his power is unlimited and he need not concern himself with the impact on the economy of sky high real interest rates. Better it would be, if he gave the markets a role in setting the exchange rate appropriate to the inflation target, rather than imposing his own assumptions, whatever they might be.
For the third year in a row, the governor appears to want to aim for the extreme bottom end of the target range, and willingly risk falling out of the bottom of it, as he did in 1991. If he continues to defy the more rational view of the markets, interest rates will continue to climb, snuffing out the domestic recovery to ensure domestic costs fall further and deflation is achieved.