graeme wheeler : forces affecting the new zealand economy and policy challenges around the exchange rate and the housing market speech by mr graeme wheeler, governor of the reserve bank of new zealand, to the institute of director, auckland, 30 may 2013. * * * thank you for the invitation to meet with you today. i would like to discuss some of the key forces shaping our economy and the challenges they present for businesses and for the reserve bank. i will focus mainly on two highly topical areas : the exchange rate and the housing market, but first let me frame them in a broader context. i ) forces affecting the new zealand economy our economy is buffeted by a range of domestic and international factors. some are driven by natural events, like the $ 40 billion rebuild activity in canterbury, and the decline in agricultural production and spending associated with the drought. some result from international conditions, like the 20 percent decline and subsequent recovery seen in our export commodity prices over the past 18 months, or the monetary and liquidity policies of major central banks that increase the upward pressure on our exchange rate. other pressures, such as house price inflation, are driven by supply shortages, pent up demand, and the lowest mortgage rates in 50 years. and others, such as the government ’ s fiscal consolidation, represent major adjustments in domestic economic policy. at the same time, businesses also face challenges in adjusting to powerful long - term structural changes that are global in nature. these include : the growing importance of china and the east asia region as a major pole for global growth and international trade ; the global transfer of skill enhancing technologies ; the relative decline in the international price of information technologies and manufactured goods ; and the rising international demand for highly skilled labour. producers therefore have many global and domestic forces to respond to. the success with which they adjust to global structural changes is also influenced by current economic conditions. for example, the challenges faced by producers competing against foreign lowcost producers, or multinationals with global supply chains, increase when our exchange rate overshoots. on the other hand, the high exchange rate makes imports of capital goods cheaper and may encourage the take up of capital intensive technologies. the interaction of multiple forces can pose difficult policy challenges for the reserve bank, although taken in isolation, the direction of their short - term impact on output, employment, and inflation is reasonably clear. for example, the high exchange rate and fiscal consolidation generally exert downward pressure on demand, output growth, and inflation. in contrast, the

patterns take time to respond to changes in relative prices. although projecting when the exchange rate may begin to head lower is a difficult task, the likely precursors for such an adjustment seem clear. as the current account deficit continues to increase, one would expect the foreign providers of capital to re - assess the relative exchange rate risk attached to their investments in new zealand dollar assets, increasingly recognising that the exchange rate cannot be sustained at current levels. in addition, a slowing domestic economy is likely to see expectations of future returns on such investments being revised down. 4. why is the reserve bank concerned about all of this? the reserve bank's interest in the current account deficit, and its associated macro - economic effects, stems from our key areas of responsibility : • our role in helping to maintain macro - economic stability. the bank is required to maintain price stability whilst avoiding unnecessary instability in interest rates, exchange rates and output ; and • our financial stability role. the bank is obliged to make sure the financial system remains resilient in the face of imbalances ( such as a large current account deficit and growing debt levels ) and subsequent adjustments that might occur. we will say more about our financial stability role when we release our next financial stability report in november. while we believe the new zealand financial system is well placed to weather strains that may be borne by its customers, we will be monitoring the risks closely as we go forward. on the price stability front, we are required to maintain inflation within the 1 to 3 per cent target band ‘ on average over the medium term '. that task has been particularly challenging of late due to several factors : • as noted, household demand has remained very strong over recent times, despite relatively firm monetary policy settings. consequently, inflation pressures have remained strong in many parts of the domestic economy, including housing and construction. • the recent sharp rise in world oil prices is putting upward pressure on inflation as higher petrol prices ‘ at the pump'and the effects of higher fuel prices risk becoming entrenched in inflation expectations. at the same time, we are expecting these increases to exert a dampening effect on household and business demand. estimating the balance of these effects is difficult. 6 / 7 • the likelihood of a more expansionary fiscal policy over the coming period has the potential to add inflation pressure in what remains a rather stretched economy. a growing fiscal surplus has clearly made higher levels of government expenditure affordable in the longer term. however, in the short