KEY POINTS:
Higher export commodity prices could mean fair value for the kiwi dollar is up to 10 per cent higher than it used to be, the Reserve Bank suggests.
In Thursday's monetary policy statement the bank reflected on why the exchange rate since 2004 has generally been well above its long-term average.
To a large extent it is because of cyclical factors, the bank says, the most important of which is the gap between interest rates here and abroad, which reflects central banks' monetary policy responses to economic conditions in their respective economies.
The effect of interest rate differentials on the exchange in turn is amplified or moderated by international investors' appetite for risk and by the sheer quantity of funds available for cross-border investment.
In recent years and until the tide dramatically turned a few weeks ago, international capital markets have been awash with money and risk appetites have been strong.
In particular the dollar has been driven higher by the "carry trade", where investors exploit the difference between Japan's very low interest rates and New Zealand's very high ones, largely disregarding the risk that the exchange rate would turn and wipe out their profit.
But these short-term cyclical influences move the exchange rate around a trend or equilibrium level. That underlying level may have fundamentally changed with what looks to be a structural improvement in the terms of trade.
The terms of trade measure the relative value of the kinds of things we export compared with the kinds of things we import.
The long-term picture is that the terms of trade peaked in the 1950s, declined until the mid-1980s, and have been on an improving trend overthe past 20 years. They are now backwhere they were in 1974.
One of the ways of estimating the equilibrium level of the currency is the "macro balance" approach, which filters out cyclical factors and focuses on the exchange rate's effect on competitiveness and the current account of the balance of payments.
Macro balance is achieved when the trend balance on trade in goods and services is consistent with the current account deficit remaining stable relative to the size of the economy, that is, as a percentage of gross domestic product.
One of the clearest indications that the dollar has been overvalued has been the current account deficit widening from between 3 and 4 per cent of GDP early in the current decade to nearly 10 per cent last year.
But in recent months the terms of trade have improved substantially, driven largely by soaring dairy prices (though other commodity prices have recently risen as well).
The Reserve Bank's modelling, using the macro balance approach, suggests that a permanent 1 per cent increase in the terms of trade driven by export prices might lead to a 0.8 per cent appreciation in the equilibrium exchange rate.
So if the 13 per cent improvement in the terms of trade this year sticks, the equilibrium exchange rate may have risen by 10 per cent - toa range focused around 63 onthe trade-weighted index.
That is probably an upper limit of plausible estimates, the bank says, because not all of the improvement in the terms of trade is expected to be permanent. And with the trade-weighted index around 68, it indicates the dollar is still significantly over-valued even after its steep recent fall.
BNZ chief economist Tony Alexander said export commodity prices in New Zealand dollar terms were 29 per cent above their 10-year average.
"This is wonderful news for the economy , which is going to go a huge way towards offsetting the expected slowdown in world growth as a result of the current liquidity crisis."
