Reframing the monetary policy debate: Some notes

Update:  Given all the links in this post, I’m adding it to the rarely used “inflation debate” tab.  An area where I rant incoherently about monetary policy in a way that is aiming to help this debate – rather than just be critical.

From what I can tell, the current debate about monetary policy taking place in the public makes little sense.  While I am sure we all mean well with our opinion pieces, the issues, the problems, the causes, and the tools aren’t really being discussed in a way that someone with an open mind can sit down and look at.  Sadly, I lack the time – and probably the ability – to give this a fair go.  As a result, instead I will just list down some things we need to keep in mind here.

David Parker has recently said two things which he used to justify the RBNZ scrapping inflation targeting, and moving to targeting a bunch of stuff:

  1. The RBNZ needs to help exporters – as other countries are helping exporters
  2. The RBNZ is to blame for our “persistently high exchange rate”

I discussed a similar post of his earlier.  But right now, I want to state that neither of these things is really true – I can 100% understand how someone could come to believe this given what we see going on around us.  However, they aren’t facts – they are fallacies.

Note:  He does mention “protecting financial stability to help exporters” – this statement doesn’t make sense.  The RBNZ does focus on financial stabilty in a seperate role, and with seperate tools – a role that is related to, but seperate from monetary policy (just like fiscal policy).  In none of this is, or should, the RBNZ look at a certain sector in NZ and say “we’re giving you stuff” – that is just wrong.

Sidenote:  If you say “but helping exporters with monetary transfers helps all of us” I will laugh – if NZ goes down that path, I look forward to having my views vindicated in 20 years time 😉

Country exchange rate fiddling?

It turns out that other countries are not helping exporters (apart from some developing nations).  The US and Europe are all involved in Quantitative Easing – which is a form of monetary policy.  We discussed this issue here and here.  QE is not “beggar thy neighbour”, it is an easing of monetary policy because domestic demand conditions in the country are too tight!  If we call this currency intervention, then we should call cutting the official cash rate, or increasing government spending, currency intervention as well!  

Note:  To make it clear, the view is that a high exchange rate slows down a recovery here – however insofar as this happens, our own central bank keep interest rates lower as a result.  As long as QE is consistent with their monetary policy mandate, the countries are not involved in trade protectionism, they are trying to make up for a shortfall in demand.  If anything this is more likely to boost demand here, and boost incomes through commodity prices – implying that arguing against it is arguing against what is in our intereset.

Central banks are not breaking the rules, this isn’t a prisoner’s dilemma – competitive devaluations HELP when demand is suppressed … just look at the Great Depression, and the choice of countries to go off the gold standard!

Persistent overvaluation?

When it comes to the “persistently high exchange rate” we can well point out that there is an issue, – not the nominal exchange rate, but the persistently high real exchange rate.  While a lift in our terms of trade should increase the real exchange rate, the constant current account deficits suggest there is in fact something going on.

However, a persistently high real exchange rate isn’t the fault of monetary policy and the RBNZ.  A persistently high real exchange rate tells us something structural is going on in our economy – it could be a sign of a government sector that is “too large”, poor domestic competition, a excessively low savings rate relative to investment opportunities in a country, or some mix of similar issues.  As a result, this has to do with competition policy, tax policy, government transfers, and the allocation of government services – but nothing to do with the Reserve Bank keeping price growth at 2%pa.  Remember, it isn’t just an issue of too much credit being offered – but too much being borrowed by people domestically who wish to investment and consume.

Remember the exchange rate is a price – it is a “signal” of real imbalances rather than the cause.  Remember, it hasn’t been the “consumption” of cars, TV’s, and baseballs that has been excessive – it has been our “investment” in housing stock prior to the crisis.  Remember that working for families was a large transfer to the middle classes – which helped to smooth income inequality, but also would have pushed up house prices and could have lifted the real exchange rate by increasing demand for non-tradables … in fact the more effective the programme has been, the larger this impact would have been.  I’m not saying that we should reverse these policies – I’m just saying that we should ADMIT they have a broader cost in terms of efficiency, one the government conveniently ignores when it markets them!

Blaming the central bank for this issue involves ignoring the actual causes of the imbalance – for a politician it involves standing up and saying “I want someone else to deal with the problem I’m partially responsible with creating”.  In that sense this is poor.

As a result, when we enter this debate let’s ask “what is the cause of NZ’s high real exchange rate” and “does the RER indicate a “market failure” or “government” failure somewhere within the NZ economy”.  These are the fruitful questions – not arbitrary attacks on the Reserve Bank.

Update:  Good article by Brian Fallow.  I don’t agree with everything in it 100% (flexible inflation targeting is occurring in a lot more places than Aus and NZ – and QE is not “beggar thy neighbour” policy), but it is an excellent discussion of the state of play – and the fact that other policy makers need to take responsibility!

10 replies
  1. Logan
    Logan says:

    Are you aware of any studies which test the Marshall-Lerner condition for NZ? From what i understand there is only a benefit if we are able to keep the exchange rate down for an extended period. It seems unlikely to me that RBNZ would be able to hold down the exchange rate themselves that long, especially when others are doing the same thing.

    • Matt Nolan
      Matt Nolan says:


      Fair point – and something that people need to keep in mind when looking at whether a suddent change in the exchange rate will give them what they desire.

      However, this is part of the reason why the focus is on the long-term real exchange rate rather than the near term impact of a level change in the nominal exchange rate.  Even if we talk about the long-term nominal exchange rate being held lower for “some reason” this doesn’t imply that the real exchange rate will be lower.

      The persistent current account deficit (persistent is the key term here) is symptomatic of something structural – it might not even be a failure, New Zealander’s may just be “more impatient” than other people.  Furthermore, this is not an issue for monetary policy.

    • Matt Nolan
      Matt Nolan says:

       Also to answer your question, I haven’t seen any recent literature on the Marshal-Lerner condition and the J-curve in NZ – I’ve seen stuff for China and the US, that’s about it 😉

  2. Blair Pritchard
    Blair Pritchard says:

    I agree with the first half of this argument but only half of the second. You say:

    “Remember the exchange rate is a price – it is a “signal” of real imbalances rather than the cause.  Remember, it hasn’t been the “consumption” of cars, TV’s, and baseballs that has been excessive – it has been our “investment” in housing stock prior to the crisis.”

    This is undercut but your earlier post of 28/8/2009 where you cited the possibility that other countries are suppressing their exchange rate. And USD2trn+ reserve accumulation by the PBOC is a good clue they are (I agree with you that the kerfuffle over QE is a furphy. It’s China and certain other USD peggers that are the issue). The SMH this week cited 23 central banks that are stockpiling AUD and there is speculation up to 80 are doing it.

    As noted by Kolinek (, neo-mercantilism is a static loss, dynamic gain strategy that has worked well for China and others. The problem is, as per the article, neo-mercantilism is great when one or two small countries are doing it, but not so great when the world’s second largest economy does it (the last part is my gloss).

    Hence Krugman, whom you cited, argued in the same link that for the US, exchange rate depreciation must be part of the rebalancing between I and S. (What he omitted is the possibility that an artificially low exchange rate may actually boost the savings rate, a proposition that I have yet to see modelled but which seems true of China).

    Hence also Warwick McKibbin’s argument that if the Chinese want to acquire AUD for prudential reasons the RBA should just manufacture currency and sell it to them.

    My net view is that the large S-I imbalance in NZ is due both to the real imbalance that you cited and also to foreign currency manipulation, in roughly equal measure. But why should we even care? Two reasons:
    1. Under the present govt, the rebalance has only been happening at about 1%/yr, which is too slow for my liking. If we want to have an economy that looks more like 25-28 = -3, which are roughly the numbers for Australia from memory, it will take ages to rebalance. (NZ’s numbers are more like 14 – 19 = -5 according to p16 of the latest Treasury chart pack.) 
    2. I am worried that if English and Joyce take strong steps to increase saving, which I would support, the RBNZ will hit the zero lower bound and there will be a demand shortfall.

    Finally, I tend to agree with your view that low saving by the household sector was not caused by flats screen TVs. It was caused by borrowing taken out with the intention of generating tax free gains in land prices. Expensive land – a pretty poor reason to run a massive CAD. (I remember seeing some modelling that showed that Labour increasing the top MTR to 39% added something like 15% to house prices!).

    • Matt Nolan
      Matt Nolan says:


      Indeed – the long-term intervention by China can be used to justify a response by policy makers here.  It isn’t a certainty that domestic intervention could be required, but there is definitely a heavy case.

      The reason I spoke out strongly against the exchange rate discussion here is because it is focused on QE – where QE is not aking to this, but is instead near term monetary policy.

      You also point out a bunch of good points – I remember a Westpac piece where they discussed the impact of the top tax rate changes on the underlying price of property.

      However, what does currency intervention by China mean for us?  We are a small open economy, a price taker.  If they continue to do this intervention, they are in essence subsidising exporters.  By doing so they push down the price of exports – improving our terms of trade.  There subsidy is an income gain for New Zealand.

      To get an “inappriopriate” amount of debt, we need not just a subsidy, but effective interest rates to be pushed down.  That, combined with the fact its been happening since that late 1970’s, is why I find the idea behind the domesticly driven savings-investment imbalance more compelling.  Undeniably neo-mercantilistic policies have exaggerated this, but the issue existed prior – and given that the neo-mercantilistic policies involve overseas countries taking on a lot of the risk (by holding a bunch of our debt as long as they wantto support their intervention), I find it less concerning.

  3. Peter Calvert
    Peter Calvert says:

    Recently I read Liam Dann ( ) arguing the New Zealand Dollar was undervalued against the USA based on the Big Mac Index. At the time of that article according to The Big Mac index the New Zealand Dollar should have been at 0.833. Today the exchange rate against the USA was 0.82. 

    My feeling is the exchange rate is right on the mark and that it is vested interest groups ( i.e. exporters ) who are arguing for my fuel bill to go up.

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