Peter Nicholl
I asked my computer the question ‘what determines a country’s exchange rate?”
The answer from AI overview was ‘a country’s exchange rate is determined by a combination of factors, including interest rates, inflation rates, trade balances, political stability and investor sentiment’. I have no idea who AI Overview is but the answer was a sensible one.
Peter Nicholl
As an example of the impacts, they said ‘higher interest rates… can strenghten a currency’. The inverse also holds true – lower interest rates can weaken a currency, especially if your interest rates are significantly lower than they are in your trading partners.
Official interest rates in New Zealand and Australia were very similar at the beginning of 2025: 4.25 per cent in New Zealand, 4.35 per cent in Australia. Since then, the Reserve Bank has lowered its Offocial Cash Rate six times, the latest on November 26 by 25 basis points to 2.25 per cent. Australia has lowered its official interest rate three times this year, by 25 points each time. Their official rate is 3.6 per cent. The gap is now significant.
The exchange rate has gone from our dollar being worth 93c in Australia on June 13 to 87.6c on November 28, a devaluation of almost 6 per cent. Given what has happened to our relative interest rates, this devaluation against the Australian dollar should surprise no-one.
It should be good for New Zealand’s economic growth as it’s good for export industries and inward tourism. Tourist numbers are growing and the fastest growth is from Australia. But New Zealanders wanting to holiday in Australia will find it costs a lot more today than it did just six months ago.
The devaluation won’t be good for inflation. Prices of imports will rise. I was surprised when I read the Reserve Bank’s cash rate decision last week that the only mention made of the exchange rate was that ‘the exchange rate has fallen supporting exporters’ income.’
Given that the Reserve Bank now has a sole target of inflation, I expected them to also talk about the inflationary effects that can follow devaluation. The bank still expects inflation to reduce from its current level of three per cent – the top of their target range – to two per cent (he middle of their target range) by the middle of next year. Despite the recent falls in the value of our dollar, they haven’t changed their optomistic outlook.
The tone of their statement last week however was more cautious than previously. They listed seven possible risks to the inflation outlook, including rising house prices, the big capital return to dairy farmers and continued inflationary pressures overseas. But the inflationary effects of a falling exchange rate wasn’t mentioned amongst their risks.
This is very surprising given that New Zealand interest rates are now significanly below those in Australia – and in most of our other main trading partners too.
By the time this column appears the Reserve Bank will have a new governor. It said in its recent decision that it has reduced interest rates as low as they can go in this cycle. They have therefore left the new governor, Anna Breman, with only a one-way option – up. Hopefully, she won’t have to do that for some time.
