Stick with inflation targeting

Dr Oliver Hartwich
Insights Newsletter
29 March, 2013

Manufacturers and exporters have been complaining about the high Kiwi dollar for a long time. Opposition politicians are openly toying with the idea of changing the Reserve Bank’s mandate to manipulate the exchange rate downwards.

The question is, if inflation targeting was abandoned in favour of managing the exchange rate, would it actually work? There are good reasons to doubt the possibility and the desirability of fine-tuning the Kiwi dollar’s exchange rate.

First, we would need to give up on either the free flow of capital into New Zealand or an independent monetary policy. Second, adjusting our own policy settings may not be enough to compensate for monetary policy excesses elsewhere. And third, changes achieved in adjusting the nominal exchange rate may not influence the real exchange rate.

To begin with, economic theory raises a monetary policy trilemma. You can only pick two out of the following three goals: a fixed exchange rate, free capital movement, and control over the inflation rate. By giving up on New Zealand’s floating exchange rate, we would have to either erect capital controls or forgo making our own monetary choices.

Since New Zealand is dependent on access to international capital markets, and since nobody wants to return to the inflation rates of the past, the best option is to stick with our floating exchange rate.

The second problem is that New Zealand’s exchange rate is determined not only by our own actions and policy choices but also by the choices of other nations. As most developed countries embark on ultra-loose monetary policies to support their struggling governments and ailing financial sectors, New Zealand would have to take extreme measures to counterbalance these foreign effects.

The negative side-effects of such a cure could be more severe than the disease. We might end up in a highly inflationary and overheated economy in which monetary stability would need to be sacrificed just to keep pace with the monetary madness overseas.

Finally, it is not clear whether New Zealand exporters would actually benefit from adjusting the nominal exchange rates. It is quite possible that such changes would only lead to export flashes in the pan until the real exchange rate returns to its previous level because of price increases in the domestic economy robbing manufacturers of the advantage of the previously lower exchange rate.

Though it is entirely understandable why exporters are campaigning for targeting the exchange rate, and it is clear why some political parties are jumping on this bandwagon, the chances of such a policy yielding the desired effects are slim.

So why give up our focus on the price stability that has served New Zealanders so well over the past 24 years?

Stay in the loop: Subscribe to updates