KEY POINTS:
Calls for governor Alan Bollard to cut the official cash rate this morning are understandable but misguided.
The Kiwi dollar is the highest it has been since it floated 22 years ago, not only against the US dollar but compared with a trade-weighted basket of currencies. And it is climbing fast.
One of the main reasons is our sky-high interest rates. So the solution seems obvious: cut interest rates and the dollar will fall.
Unfortunately it is not that simple. Such a move would certainly have shock value, when the market is expecting Dr Bollard to raise the official cash rate (OCR).
But for such a move to have the desired effect it has to be credible. The market has to be convinced it is more than a Mickey Mouse stunt, that it can and will be followed by more of the same.
The brutal reality is that as long as we have an inflation target and an inflation problem, interest rates will stay high.
As former governor Don Brash, who faced the same problem in the mid-1990s, said last week, "The quickest way of getting the exchange rate down is to make it unambiguously clear that the Reserve Bank will do whatever it takes to get domestic inflation under control".
It isn't yet. Domestic or non-tradeables inflation is all those prices in the consumers price index which are not affected by world prices or the exchange rate and which are supposed to be within the reach of the bank's interest rate settings.
It has been running at 4 per cent or thereabouts for nigh-on four years now. Overall inflation has averaged 2.9 per cent over the past three years, but only because the exchange rate has been painfully high for most of that time, pushing down the prices of imported goods.
It leaves Dr Bollard, charged with keeping inflation under 3 per cent on average over the medium term, with no margin for error.
He has exercised his mandate to give the economy the benefit of the doubt, all through last year, only to be disappointed. But while he might not yet have inflation beaten, he at least has it cornered.
Although the proportion of firms reporting that they expect to increase their prices remains high, overall business confidence is falling. So is consumer confidence.
If that continues, it should mean firms become more wary about passing on their increasing costs to their customers, for fear it will cost them too much in lost sales and market share.
There are also signs - still ambiguous and tentative - that the heat may be going out of the housing market.
A lot of mortgage debt, about a quarter of the total, comes up for an interest rate reset over the next 12 months. Those borrowers, now paying an average rate of 7.8 per cent, will struggle to find a new rate below 9 per cent, but only if the Reserve Bank is able to keep its end of the interest rate curve up.
In this environment, an interest rate cut that would take the pressure off domestic inflation is the last thing business needs.
The persistence of domestic inflation over the past four years testifies to how difficult it is to bring down those prices, to which exporters as well as other firms are exposed. Higher interest rates are not the only thing putting upward pressure on the exchange rates, of course.
The Japanese yen and US dollar are both weak, and so, therefore, is the Chinese yuan, which is more or less pegged to the US dollar. That is a lot of weight on the other end of the exchange rate seesaw.
Global investors also have a hearty appetite for risk, including the very substantial risk of holding New Zealand dollar-denominated assets at these exchange rates. New Zealand can do nothing about any of these things.
Nor can we affect another source of support for the currency - historically high commodity prices, especially for dairy products. We wouldn't want to, in any case.
That leaves the pathway that goes from lower domestic inflation to sustainably falling interest rates to a weaker currency. But we can't skip the first part.
In the longer term things can be done to reduce the risk of getting into this pickle again.
One of the sources of primary demand for New Zealand dollars - as opposed to the hot money, speculative kind - is our abject reliance on importing foreigners' savings. New Zealand households want to borrow far more money than other New Zealanders want to lend, mainly to buy housing.
As long as housing is a no-go area for the tax man that is liable to continue.
The other thing is that the economy's "speed limit" is much too low. That is how fast demand can grow before it hits the inflationary wall, outstripping the supply side of the economy's capacity to meet demand.
Raising that comes down to lifting productivity, which is easier said than done. And giving the New Zealanders who, in increasing numbers, are taking their skills and entrepreneurial vigour to Australia or further afield, a reason to stay.
