Background Information on the Reserve Bank's Proposal to Extend the Purpose for Which It Holds Foreign Exchange Reserves: 17 March 2004
1 On 11 March 2004, the Reserve Bank announced that it had provided advice to the Minister of Finance recommending that, as one of its monetary policy tools, it should have the capacity to intervene in the foreign exchange market to influence the level of the exchange rate. The press statement containing that announcement is attached.
2 The following is background information on the Reserve Bank's proposal and what would be required to implement it.
Why is the exchange rate an issue?
3 The amplitude of the New Zealand exchange rate cycle has long been a concern. The exchange rate varies across the cycle to a far greater extent than the underlying economic situation warrants. That is, the degree of exchange rate variation goes beyond that which is useful to the economy in terms of absorbing economic shocks and motivating business and household to adjust to lasting changes in New Zealand's external trading situation. Excess exchange rate variation makes engaging in business more difficult, reducing investment and thereby restricting the opportunities for New Zealand's growth. Excessive exchange rate variability can also make the Bank's task of achieving and maintaining price stability more difficult, potentially leading to unnecessary output, inflation and interest rate variability.
4 This excess variation is not confined to the New Zealand dollar. It is a feature of floating exchange rates--and indeed the New Zealand dollar is not the most variable exchange rate amongst the developed country group. Nor is it a new issue. But as inflation has been brought down and stabilised around the world, and as a result economies have become more stable overall, exchange rates cycles have not noticeably diminished. Excessive exchange rate variation stands out more obviously in this context as an unresolved issue.
5 In response, in the Reserve Bank's 2002/2003 Annual Report we stated that one of our priorities for 2003/2004 was to "continue to develop and communicate a better understanding of the implications of the exchange rate and its volatility for economic performance, and policy options to affect the exchange rate". These proposals are a result of that work.
What is the Reserve Bank suggesting?
6 The Reserve Bank is proposing that when the New Zealand dollar is exceptionally and quite clearly unjustifiably high, the Reserve Bank could sell New Zealand dollars to buy foreign exchange, in a manner designed to put downward pressure on the exchange rate. Equally, when the exchange rate is exceptionally and clearly unjustifiably low, we could sell foreign exchange to buy New Zealand dollars, in a manner designed to put upwards pressure on the exchange rate.
7 Selling and buying New Zealand dollars might initially seem to involve changing monetary policy by altering the New Zealand money supply. However, it is important to note that the intervention would automatically be "sterilised" to undo the effect on the money supply. This is standard practice internationally.
8 In principle, any effect of intervention on the exchange rate would have implications for inflation, and therefore for monetary policy. We do not expect to intervene very often or to be able to alter the exchange rate by a sufficiently large amount to make this a substantial issue. But to the extent that we are able to affect the path of the exchange rate through foreign exchange market intervention, that would be taken into account in our interest rate settings.
9 To the extent that intervention was able influence the exchange rate, we would have a small amount of additional capacity to fulfil our Policy Targets Agreement obligations. Those obligations are to maintain medium term price stability while avoiding unnecessary variations in the exchange rate and the economy in general. Depending on the circumstances, those obligations could be better fulfilled by a slightly smaller exchange rate cycle coupled with a slightly greater inflation cycle, or by a slightly greater interest-rate cycle. …