Thursday, September 09, 2010
Vital Statistics
22 Aug 2007
Comments on recent Reserve Bank interventions
As we go to press markets are digesting a welcome but overdue activation of the Reserve Bank’s powers to intervene in the foreign exchange market. If the Bank attempts to manage the rate down too far, it will probably fail. But if, from now on, it frequently enters the market for short bursts, both buying and selling NZ$s, in order to prevent speculation either way, the NZ$ could decline significantly as speculative interest dissipates and as its level becomes based only on the fundamentals of terms of trade, savings levels and interest rates. Only time will tell by how much this speculative element has kept the rate above levels determined solely by the fundamentals.
To achieve a greater devaluation while still maintaining high interest rates, the Bank would need government support in the form of unlimited capital injections by government and action in the bond market to sterilize the NZ$s issued in the process of managing the rate down.
 Note that intervention to devalue a currency is more manageable than intervention to prop it up. The latter (i.e. attempts to prop-up a currency) was the case when the Bank of England lost the battle against George Soros in 1992. On that occasion, the Bank of England ran out of foreign exchange with which to buy Sterling back.
However, when attempting to manage a rate down (as is our case now) the limit on the operation is not so stark. The limit consists of the power of a central bank to create its own currency, which is theoretically unlimited. Japan is the classic example here. Not only have their authorities maintained an undervalued currency virtually throughout the post-war period, but they have achieved low rates of inflation notwithstanding their interventionist activities.
In the New Zealand context, a managed devaluation is not to be recommended beyond a certain point. While it enables exporters to prosper it is disadvantageous to consumers who must suffer a lower real income due to the high price of imports. A possible ideal is to establish a rate which achieves a sustainable current account balance of payments.
Since our last issue, the Reserve Bank has upped the Official Cash Rate (OCR) twice by 25 points each. The first, on April 26 was fully priced in by the markets as shown by five subsequent weeks of stability in the 90-day bill rate around the 8.10% level. The second, however, on June 7, was only partially priced in with the 90-day rate at 8.16%, which rose immediately afterwards by 20 points to 8.36%. Not only was the increase in the OCR itself largely unexpected but so also was the more hawkish tone of the accompanying commentary. It was this that stimulated greater speculative increase in the value of the NZ$. The TWI had tended to decline in the period after the April review. It stood at 71.0 the week before the June review. It rose sharply to 73 on the eve of the review and then to a peak above 74.6 when the Reserve Bank stepped in. Demand for the NZ$ was across the board, but particularly from the US and Japan. As we go to press the intervention has been modestly successful in bringing the TWI back to around 73.
Another development of major importance to the monetary scene is the very attractive terms of the KiwiSaver facility announced by Finance Minister Cullen in his 2007 Budget last month. Insofar as the scheme is taken up - Treasury expects 50%, but we would not be surprised if the take-up rate was higher - and is not offset by reductions in other forms of saving, it must affect the level of demand.
Our expectation is that it will take the heat off the Reserve Bank as the scheme is phased in. We expect three favourable impacts as follows.
· Reduced demand leading to less inflationary pressure, particularly in the housing market as individuals adjust to lower discretionary income. This should enable the Reserve Bank to reduce the OCR.
· Some diversion of savings to foreign investment as savers opt for portfolios with an overseas component. This increased demand for foreign currency, along with a lower OCR, should reduce upward pressure on the NZ$.
· In addition, markets could anticipate this reduced pressure, thereby easing the NZ$ even ahead of the event.
Having said all that, we should not overlook the possibility that the neo-classical view regarding savings schemes will prevail in Reserve Bank circles and also the markets. This view is that savings in KiwiSaver will be offset almost entirely by reduced savings elsewhere. Impacts would be a net zero and the Reserve Bank would have to retain its current stance.
While recognizing the neo-classical factors, our view is that they will be far short of completely negating the KiwiSaver. Our reasons are: the locking in effect of the scheme, the easy entry and the possibility that much failure to save is due to inertia rather than a positive decision to consume instead.
The two increases in the OCR since our last issue of BERL Forecasts have been accompanied by a major change in the yield curve. Thus the 90–day rate has risen in line with the OCR, (i.e. by 49 points from 7.81% to 8.30%) but the 10-year stock yield is up by 98 points from 5.83% to 6.81%. The reverse yield gap has fallen from 204 points to 149. About half can be ascribed to a world-wide rise in 10-year bond rates (e.g. the Australian rate has gone from about 5.7% to 6.3%), but the remainder could be due to expectations of more inflation. This is suggested by the yield on the 10-year inflation adjusted bond having increased by only 20 points from 3.52% to 3.72% over the period, implying an expected inflation rate of 3.1% compared with 2.3% when we went to press last time.
The future outlook for interest rates is even more difficult to predict than usual. On the one hand the Reserve Bank’s hawkish stance signals further increases, especially in light of the apparent worsening of inflation expectations by the market. On the other hand, the immediate introduction of the KiwiSaver facility could significantly dampen inflation. Our view is that the former will prevail in the short run with the latter affecting the long-term outlook. On this basis, we expect interest rates to remain at present levels for the rest of this year, with some decline in the latter-half of calendar 2008.
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