The Reserve Bank Governor (2013) versus the Labour Party on whether its monetary policy upgrade will increase the inflation rate and destabilise the exchange rate

Attempts to keep the dollar from going “too high” would have ruinous domestic consequences as the Governor of the Reserve Bank explained last year:

If New Zealand decided to cap the NZ dollar, depending on where the cap is enforced, similar levels of intervention might be required as global foreign exchange turnover in NZ dollars relative to GDP is similar to that in Swiss francs.

The OCR would need to drop to zero first in order to eliminate the interest arbitrage motivation for NZ dollar inflows. Any attempt to retain non-zero interest rates by “sterilising” such massive intervention would be very difficult.

In effect therefore a Swiss type operation to cap the value of the NZ dollar through large scale FX intervention would also amount to quantitative easing. As I mentioned, this would be highly inflationary in the NZ context.

Graeme Wheeler, Governor of the Reserve Bank of New Zealand

20 February 2013

Manufacturing decline not just a dollar story A speech delivered to the New Zealand Manufacturers and Exporters Association in Auckland

Sterilised interventions in the foreign exchange market are a fool’s errand

If exchange rate manipulation had any chance of working, the U.S. Fed, the Bank of England, the European Central Bank and the Bank of Japan would be all over it already. Their mutual efforts to depreciate their own currencies would cancel out.

Most central banks gave up on exchange rate interventions in the mid-1990s because attempts to manipulate exchange rates without loosening monetary policy rarely worked.  Brute experience taught them that they were on fool’s errand.

These exchange rate interventions, known as sterilised interventions, become an independent source of exchange rate instability and invite counter-speculation by currency traders and hedge funds. Every hint that a central bank might intervene in the exchange rate invites currency speculation. As Milton Friedman said:

The central problem is not designing a highly sensitive [monetary] instrument that offsets instability introduced by other factors [in the economy], but preventing monetary arrangements becoming a primary source of instability…

By trying to move the value of the dollar, the Reserve Bank of New Zealand will add its own element of currency instability and invite counter speculation by currency traders and hedge funds. This is a dangerous game for a small Reserve Bank to play.

As stated by Paul Krugman in 1999 on the concept of the impossible trinity: free capital movement, a fixed exchange rate, and an effective monetary policy –

The point is that you can’t have it all: A country must pick two out of three.

It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain – or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today or for that matter most of Europe).

Exchange rate manipulation by the Reserve Bank cannot alter the competiveness of exporters. The looser monetary policy will inevitably lead to higher CPI inflation that will erode any temporary advantage to exporters from the initial depreciation of the NZ dollar.

What did the Swiss do to keep their exchange rate down in the GFC?

Labour’s Monetary Policy Upgrade referred to the efforts of the Swiss National Bank to cap a massive appreciation of the Swiss Franc after 2009 and the Euroland sovereign debt crisis:

The Swiss have actively protected their currency from appreciating to the detriment of their tradeable sector (p.16)

The Swiss National Bank stemmed the rise of Swiss franc by loosening their monetary policy as they say so themselves:

The Swiss National Bank has successfully maintained its exchange-rate floor against the euro, often through heavy nonsterilized purchases of foreign exchange (Swiss National Bank Annual Report, 2012, p. 34).

These non-sterilised exchange rate interventions were a loosening of Swiss monetary policy. The Swiss National Bank happens to be one of a number of central banks that conduct their monetary policies by buying and selling in the foreign exchange markets.

Labour’s aim of a positive external balance through a tightening of monetary policy is a repeat of the fool-hardy policies of the Hawke-Keating government in the late 1980s.

1988 witnessed a major monetary policy tightening in Australia. The tightening was motivated by a current account deficit rather than double-digit inflation:

  • The inflation rate fell to below 3% in 1991.
  • The current account did not change much as a result of the deep recession and 10%+ unemployment rate designed to bring it under control.

The current account deficit as a major policy problem was then quietly forgotten in Australia.

Three conflicting monetary policy objectives

The New Zealand Labour Party wants the Reserve Bank to do three impossible things before breakfast:

  1. Loosen monetary policy to bring the dollar down such as in Switzerland after 2009;
  2. Tighten monetary policy to reduce the current account deficit such as in Australia after 1988; and
  3. Loosen and tighten monetary policy as required to stay within the inflation target.

The best contribution of monetary policy to the competitive positions of exporters is low inflation.


Inflation targeting removes monetary policy as in independent source of exchange rate instability. Attempts to manipulate the exchange rate undermines the inflation target that has been such a great success since 1989, and reduces the commitment of public policy to a stable, predictable business climate. Bordo and Humpage add:

…sterilised foreign-exchange intervention can sometimes affect exchange-rate movements, but sterilised intervention does not provide central banks with a mechanism for systematically altering exchange rates independent of their monetary policies.

Attempts to stabilise or undervalue exchange rates necessarily weaken a country’s control of its monetary policy and ultimately leave the real exchange rate unaffected.

What really matters?

Labour’s monetary policy upgrade is a distraction from the only game in town for the future prosperity of New Zealanders:

Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.

Paul Krugman

The Age of Diminishing Expectations (1994)


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