Academic journal article The Reserve Bank of New Zealand Bulletin

Making Sense of a Rising Exchange Rate. (Speech)

Academic journal article The Reserve Bank of New Zealand Bulletin

Making Sense of a Rising Exchange Rate. (Speech)

Article excerpt

My subject today is "Making sense of a rising exchange rate". The exchange rate has risen sharply over the last year or so, and has become the stuff of media headlines in ways not seen for some time, and the concern of exporters which I acknowledge. I'm going to sketch out our broad interpretation of what has been going on, and outline for you something of the way that the Reserve Bank thinks about the exchange rate in making monetary policy.

For several years, of course, the New Zealand dollar fell quite sharply. It settled at levels that, against almost any yardstick, were too low to be sustained. That is so whether measured against the US dollar or in effective (trade-weighted) terms. Little more than two years ago, our dollar was trading at only 39 US cents - 30 per cent below the average for the whole of the last 10 years. Even in trade-weighted terms, our exchange rate spent most of 2001 almost 15 per cent below its 10 year average.

When New Zealanders think about our exchange rate, we tend to think about what is going on here. In fact, that is only half (or less) of the story. The exchange rate is the price of our money in terms of other countries' currencies, so what is happening in other countries, and what investors are thinking about opportunities elsewhere, matters greatly.

In the long run - and, if you are a struggling exporter, that can be a very long time-exchange rates reflect long-term actual economic fundamentals: things to do with the underlying competitiveness of our economy and its firms. If our productivity performance outstrips that of other countries, our exchange rate will tend to rise. If our inflation rate is consistently higher than those of other countries, our nominal exchange rate will tend to fall. And so on. But that is for the long run.

In the shorter-term it is largely a matter of making sense of fluctuations in the demand for funds and in the willingness of the world's savers and investors to supply them. The demand for investors' funds (loosely, the state of the current account of the balance of payments) does not tend to shift very quickly. Instead, changes in the attitudes and perceptions of financial market participants - changes in their willingness to supply funds - tend to be behind most exchange rate changes. To be concrete, in which country and in which sorts of assets do they think that returns will be greatest? Those perceptions and attitudes can be well-founded, or out of line with reality for a number of years. At times, they can shift quickly.

In an ideal world, perhaps, the exchange rate would move simply to reflect actual economic fundamentals - both long-term factors such as structural changes in our relative productivity performance, and medium-term differences in economic cycles. The exchange rate would provide accurate signals to producers, and act as a buffer to temporary pressures. In fact, exchange rates are more volatile than this. Sometimes the moves prove to be well-grounded in economic fundamentals, but by no means always. And exchange rates (like share prices) fluctuate more than the underlying economic fundamentals. New Zealand's exchange rate is a little more variable than most, partly because our economic fundamentals are more variable than those in larger and less commodity-dependent countries. So when it comes to exchange rates we live in an imperfect world - less than ideal, but in my judgement (and we have done a lot of work in this area over the years) still better than the alternatives realistically on offer.

Turning back to our own experience in recent years, the framework I outlined a moment ago does help make sense, broadly speaking, of the exchange rate movements in the last few years. For several years, investors globally were taking a gigantic punt on events in the United States, the leader of the "new economy". They convinced themselves that the United States offered the best returns - the economy was growing rapidly, corporate profits were expected to get ever better, and share prices rose seemingly inexorably. …

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