I like the crusade call – both for its positive and negative connotations 😉

With regards to the size of the FX market, I would be careful reading too much into that. Generally highly liquid markets should be less vulnerable to bubbles, not more vulnerable, and so this is really a good thing.

With regards to foriegn intervention, lets think about that issue for a second. Foriegn economies are highly depressed, and are trying to close their output gap/reach inflation outcomes that meet their mandate. In that situation, their monetary stimulus does have a spillover impact on us.

However, this isn’t an argument for them to not meet their mandate.

Now our own central bank is setting monetary conditions such that we meet our output-inflation target. Cool. If interest rates here are truly that much higher than overseas, we are just inherently stronger than they are.

Now you rule this out, and state that the high dollar is not to do with interest rates, or forward looking commodity prices, it is instead due to … say … a bubble in bond markets. Ok, so foriegn central banks are willing to transfer New Zealand wealth for some reason, and this has pushed up the dollar (note if they were doing it by pushing inflation past target, then the nominal currency appreciation makes sense as a forward looking price, it isn’t a bubble).

It isn’t clear to me that New Zealand is the place struggling in all of this.

Boris, my argument was that the explanatory power of interest rate differentials peaked a few years ago. There is something else going on. Regarding foreign CB intervention, I agree with the views of ANU Prof Warwick McKibbin expressed here: http://tinyurl.com/aqyvmb2. Excerpt: “The general point is that even though allowing markets to work is usually the best policy, when markets are distorted by the policies of foreign central banks, it might be better to deal directly with the distortion rather than allowing markets to propagate the shock unnecessarily”.

Yeah… nah… I think you are over thinking it a bit. The exchange rate is a relative price that reflects both the reality and expectations about the future.

Now given the state of the world a freely floating currency in a relatively stable economy is a good place for people to park their money – low risk of a blow up… NZ has structurally high real interest rates and thus a structurally high real exchange rate because of the issues Matt has noted.

The overvaluation comes because of the risk preferences for NZ dollars vs other currencies – if the world becomes more stable economically then one would expect the overvaluation to dissipate…

Although I know plenty of people who have predicted a return to fundamentals for a long time… they are still waiting….

I totally agree with your crusade for 1. let’s fix the real economic imbalances first and 2 NZ does not need QE. However, I still have some doubts…

In my experience, economists don’t describe FX markets well. The story you are describing is a real economy story and this doesn’t match up with what you see in markets, which is turnover of 15x GDP or so. I think that the current world of “flow” products, prime brokerages, derivatives, ETFs and central bank buying is more complicated and this is why currencies tend not to behave in ways that economists expect. I’ve tried talking to FX traders about who’s really trading with whom in the FX market and I’m not sure they even know. Second, it’s at least plausible that funny money abroad is in part responsible for distortions in our real economy. For example, foreign HF/CB buying causes us to run a capital account surplus, and the real economy adjusts by reducing production relative to consumption+investment such that we get a balancing current account deficit. In other words, inadequate domestic saving is likely made more inadequate by money creation by foreign HFs (or their prime brokers) and CBs.

Similarly the RBNZ research you link to is incomplete because it looks almost entirely at macroeconomic variables. These are only relevant because they influence HF behaviour.

My own view, which is based on observing the markets, is that FX used to be real economy driven until about the 1980s, then became a story about interest rate differentials, and more recently became dominated by portfolio rebalancing effects. I have not seen any academic write knowledgeably about this modern world except perhaps Michael Pettis who used to be a trader at Bear Stearns. You may be aware of others.

If the above theory was correct you would expect to see a large and persistent CAD in NZ, low saving, and low investment (because the high RER has pushed down the marginal return to capital across the curve). This is what we are seeing – investment still hasn’t recovered since the GFC.