At last, strong NZ dollar helps fight inflation

The surge in the New Zealand dollar to two decade highs is proving to be an unexpected blessing for the central bank in its battle to keep inflation within its target band.

The strong currency is helping to dampen the prices of imports, including major cost drivers such as oil, which along with signs of cooling domestic demand might prompt the Reserve Bank of New Zealand to tone down its rhetoric on inflation, some analysts say.

"We think it is a leg in a broader argument as to why they might be able to soften their tightening bias," said Craig Ebert, senior economist at Bank of New Zealand.

The currency's strength had the opposite impact last year because cheaper imports fuelled consumer demand, inflaming inflation.

But analysts say that is unlikely to happen this year because retail spending growth and house price inflation are clearly slowing down as New Zealanders feel the pinch of record high interest rates.

The central bank lifted rates four times last year to 8.25 per cent, the highest in the industrialised world, and said in late January it was likely to keep them there in the coming months to combat rising food and oil prices.

The central bank will announce the result of its latest policy review on Thursday. It is widely expected to keep rates on hold and reiterate its January message.

But the currency's strength is now providing an additional tool helping to bring inflation under control, which will allow the central bank to become less hawkish as the year progresses, economists say.

Indeed, the median forecast in Reuters latest poll on interest rates is for cash rate to come down to 7.75 per cent by March 2009.

Annual inflation jumped to 3.2 per cent in the fourth quarter, above the central bank's 1 per cent to 3 per cent target band, driven mainly by surging energy and food costs.

The central bank has voiced on several occasions its concern that inflation expectations are not given more strength by spilling over into wage and price setting behaviour.

According to a central bank report in 2001, a 10 per cent movement in import prices translates into a 0.5 per cent change in consumer prices in the immediate quarter and a 1.5 per cent change over the longer term.

Boosted by its attractive yield appeal and falling interest rates in the United States, the New Zealand dollar has gained around 5 per cent this year, hitting $0.8215 last week, the highest level since the currency was floated in 1985.

Despite its strength against the US dollar, the New Zealand currency has fallen around 2 per cent this year against the Australian dollar, which has been boosted by the Reserve Bank of Australia's renewed monetary tightening policy.

Analysts say the high exchange rate against the US dollar caps prices of key US dollar-denominated imports, such as oil and commodities, but its relatively weak rate against the Australian dollar provides support for exports.

"When you're around about that 85 Aussie cent level, that's a pretty realistic exchange rate to do business at," said Nick Tuffley, chief economist at ASB Bank.

Australia is New Zealand's biggest trading partner, buying about 20 per cent of its total exports.

This favourable mixture could also be what has kept the central bank from intervening in the foreign exchange market, unlike last year, economists say.

Last June, the central bank surprised the market by intervening for the first time since the currency was floated, saying it was unjustifiably high.

But this year the central bank may feel intervention is not needed because of the relative steadiness in the Kiwi/Aussie cross rate.

"It will be a concern for them but not enough to start intervening actively in currency markets like they did last year," said Khoon Goh, senior economist at ANZ-National Bank.

RBNZ Governor Alan Bollard said in late January the currency was still broadly over-valued, although it was mainly due to the weakness in the US currency. (Reuters)