The Higher Current Account Deficit
Will the high current account deficit force the RBNZ to accept higher medium-term inflation?
New Zealand's structural current account deficit may lead to persistent NZD weakness during this economic cycle.
With the central bank obliged to pursue its 0-3% inflation target subject to minimising adverse effects on the real economy, the RBNZ is unlikely to raise interest rates to the extent that would fully offset the currency weakness.
The result could be a multi-year adjustment process involving inflation tracking above 2% - with an upward adjustment in inflation expectations likely to make it increasingly costly to embark at some stage on renewed disinflation into the 1-2% range.
The interface of current account adjustment and monetary policy, as well as the long-term consequences for New Zealand's inflation performance, may be issues investigated in the Government's forthcoming review of monetary policy.
Structural current account deficit requires adjustment
The NZ dollar's response to New Zealand's chronically high current account deficit could become a major problem for the RBNZ during the current monetary policy cycle. As Governor Brash has commented before, while he has little ability to influence the deficit, the external imbalance can create difficulties for monetary policy.
New Zealand's current account deficit is of a structural nature. Even with the world economy returning to full capacity, climatic conditions remaining favourable, and the export sector regaining broad strength, the deficit is unlikely to fall below 6% of GDP.
That level of deficit suggests that New Zealand's external liabilities will continue to grow at a faster rate than GDP - a trend that has to be described as unsustainable. The underlying problem is that high import growth rates are constraining the recovery of the trade surplus. A growing trade surplus, however, is the key to providing a significant offset to the chronically high investment income deficit, which is tracking at around 8% of GDP.
The required adjustment of the external imbalance would involve a rising share of the export sector in the economy and a correspondingly lower share of domestic demand. Such a development would be facilitated by a mix of monetary conditions that involves a comparatively low exchange rate (to ensure export sector competitiveness) and comparatively high interest rates (to keep domestic demand in check).
Monetary policy cycle with a comparatively weak exchange rate?
>From a pure monetary policy perspective, the requirements for the trend in monetary conditions are likely to be somewhat different from those focused only on facilitating external adjustment. While rising interest rates are consistent with slowing domestic inflation pressures, indicators of future inflation suggest that a significant NZD appreciation will be required as well.
The RBNZ factored a 10% rise in the NZD over the next two years in the inflation forecasts published in November. Such an appreciation was projected to ensure that medium-term inflation would track around the 1.5% mark. The RBNZ is aiming medium-term policy at 1-2% inflation in order to minimise the chances of breaching the official 0-3% target on either side.
It is our view that a currency appreciation greater than 10% will be required in order to meet the 1.5% inflation goal, considering - rising world commodity prices; - a gradual strengthening of broader world inflation measures; as well as - a domestic economy that is at full capacity and continues to grow at 4% per annum.
However, latest NZD trends have given rise to the question of whether high rates of appreciation are achievable during this cycle. The backdrop for the NZD is certainly less favourable than during the last upturn: the current account deficit is at a significantly higher level, the Government has dis-continued the state asset sale program, hedge fund activity is likely to be less supportive, etc.
That leaves the question of whether New Zealand can re-create the high interest differentials that existed in the mid-90s and provided support for the NZD. While the domestic economy is strong, it is less buoyant than in the mid-90s, particularly in the housing market. Furthermore, household debt levels are significantly higher now. That suggests that a return to domestic short-term interest rates of 9-10% would not just slow demand growth, but most likely force the domestic sector into recession.
The result: structurally higher inflation in the 2.0-2.5% range?
A domestic recession as a consequence of the RBNZ - in pursuit of 1- 2% inflation - responding to a weak exchange rate would be inconsistent with the Policy Targets Agreement (PTA). The PTA requires monetary policy to be conducted in a manner that maintains inflation in the 0-3% range, subject to minimising adverse effects on the real economy.
In the spirit of the PTA, the optimal approach to monetary policy in this situation would probably involve the acceptance of an inflation rate above the RBNZ's preferred 1-2% range, but still below the 3% target ceiling. A 2.0-2.5% range could be an acceptable compromise, with interest rates raised only to the level required to prevent inflation from accelerating further.
The magnitude of the current account deficit suggests the need for a multi-year adjustment period involving a comparatively low exchange rate track. However, actual inflation moving in a 2.0-2.5% range for a prolonged period of time would most likely cause a corresponding rise in inflation expectations - thereby making it increasingly costly to embark at some stage on renewed dis-inflation into the 1-2% range.
As we have argued in the past, the economy may settle more comfortably at a somewhat higher level of inflation, which would be consistent with the targets pursued by a number of other central banks, including the US Fed and the RBA. The pursuit of sustainable dis-inflation into the 1-2% range in New Zealand over the past decade may have been too ambitious, with the corresponding overvaluation of the NZD in the mid-90s having contributed to the rapid worsening of the external deficit.
An issue for the Government's forthcoming monetary policy review?
Given persistent currency weakness and a widening current account deficit, the issue of external adjustment and its interface with monetary policy is becoming increasingly topical. It may therefore be included in the monetary policy review planned by the Labour/Alliance Government for this year.
With the current 0-3% inflation target range able to accommodate the external adjustment process described above, there appears no need to change the parameters of the monetary policy framework in response to this issue. However, it is essential that the RBNZ and the Government agree on how to interpret the framework with respect to this matter.
Ulf Schoefisch, Chief Economist, New Zealand,