By BRIAN FALLOW
WELLINGTON - Cycles - and potentially large cycles - in the exchange rate are largely unavoidable, says the Reserve Bank in a briefing paper for the new Coalition Government.
It says moves the bank has made towards a more medium-term horizon in its inflation-targeting may help to moderate future cycles, but only at the margin.
The bank has draw fire for the heights, painful for exporters, that the dollar reached in 1996 and 1997 at the peak of the last monetary policy cycle.
The bank says it is not possible to set interest rates to keep both inflation and the exchange rate stable simultaneously.
"When capital markets are as integrated internationally as they are today, capital responds very quickly to interest differentials, and in doing so moves the exchange rate. Thus interest rate movements directed at inflation pressures inevitably also move the exchange rate. Hence monetary policy in an open economy is transmitted via both interest rates and the exchange rate."
The bank said it could not rule out the possibility of another strong cycle in the exchange rate.
"However, it is also possible that the next exchange rate cycle may be more muted, with interests rates plying a greater role in stabilising inflation pressures. This could be the case if, because of the size of our current account deficit and already very high level of obligations to the rest of the world, rising interest rates do not attract such large capital inflows."
The bank acknowledges that the high dollar puts pressure on the competitiveness of exporters and firms competing with imports, but says exposure to real interest rate cycles is an inherent risk for firms operating in the tradeables sector.
"Certainly an aim of monetary policy should be to avoid amplifying these cycles, but it would be wrong to suggest monetary policy can eliminate them."
However, the overall tenor of the briefing paper suggests a more relaxed and flexible approach towards inflation-targeting.
There is a recognition that too strict an approach to keeping inflation with bounds can mean an undesirable degree of fluctuation in economic output and interest rates.
"The key is to keep inflation expectations anchored around price stability. Provided this can be achieved, some short-term variability need not cause for concern.
"Even where policy is consistently directed at keeping inflation within the 0 to 3 per cent range, annual consumer price inflation outcomes can be expected to fall outside that range about 20 per cent of the time ... We think this strikes an appropriate balance between the need for flexibility in the framework and the need to anchor inflation expectations."
The bank says while New Zealand in the 1990s has made some progress in arresting its relative economic decline, outcomes have fallen short of what was hoped for early in the decade. It says that the best contribution it can make to economic growth is to deliver sound money so price signals are clear.
It says the factors that would sustainably lift living standards fall outside its area of responsibility. They are:
* The efficiency with which resources are allocated. This concerns avoidance of distortions in areas such as taxation, regulation and external trade barriers.
* The quality of the resources available and how well we use them. This is about technology, skills, management and entrepreneurship.
Exchange rate surge 'unavoidable'
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