anthony byett economist fxmatters november 2006
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Money and Monetary Policy Interest Rates Exchange Rates. Anthony Byett Economist fxmatters.co.nz November 2006. Money and Banking. Definition of money NZ banking system Money in NZ. Review Introducing a stock into the flow model. Money is a stock concept measured at a point in time - PowerPoint PPT PresentationTRANSCRIPT
Anthony ByettEconomist
fxmatters.co.nz
November 2006
Money and Monetary Policy
Interest Rates
Exchange Rates
Money and Banking
Definition of money
NZ banking system
Money in NZ
ReviewIntroducing a stock into the flow model
Money is a stock concept
– measured at a point in time Income is a flow concept
– per annum concept
Households FirmsGoods & services
produced from
capital & labour
Refer Callander2nd Ed p360
Forms of Money
Utu, favour exchange
Gold, greenstone, cigarettes
Notes & coins
Transaction accounts– access by cheque, EFT-POS, telephone
Savings accounts– NB some accessible by ATM, telephone
Debit cards (as opposed to credit cards)
Refer:* The Economist 22-Dec-01 pp85-87
Medium of exchange. In order to function it must have the following properties:
- acceptable - scarce- portable - divisible - durable
Store of value
Unit of account
Means of deferred payment
Functions of MoneyWhy hold money?
Refer Callander 2nd Ed p533
Money in NZHow much?
Recent figures put money = $171 billion– I.e. Jun-06 “M3 money supply” reported by RB
– including $2.8 billion notes & coins
– remainder were bank deposits
Had been $93b in Mar-99– breakdown of this figure to come in following
slides
Banking in NZInstitutions
Government > collects taxes & borrows money > buys goods & services, pays
benefits
Reserve Bank > banker to Government & banks > supervises registered banks
> implements monetary policy
> issues currency
DMO > Government’s Treasury
Registered banks > accept deposits/makes loans
> manage pooled investments
> process transactions
Other financial institutions
M3 Financial InstitutionsOwners, assets ($b) and S&P credit ratings
1 ANZ National ANZ, Aus 87 AA-2 WestpacTrust* Westpac, Aus 48 AA-3 BNZ NAB, Aus 46 AA-4 ASB Bank CBA, Aus 42 AA-5 Hong Kong* HK Shanghai 6 AA-6 Deutsche Bank* DB, Germany 6 AA-TSB NZ trust 3 BBB- Others (3 banks/sub & 2 non-bank)13 TOTAL (at Dec-05) 251
* Branches
Note: Kiwibank ($2.5b) is a bank but not within M3 survey (yet)
Source: www.rbnz.govt.nz and www.kpmg.co.nz
Balance Sheets of Banks
Assets Liabilities
+ Loans - Deposits
+ Reserves - Capital
(or liquids)
NB: deposit is– customer’s asset, and
– bank's liability (as owed customer)
Refer Callander2nd Ed p535
NZ “M3” Balance SheetASSETS (Mar-99 total=$143b) $b
NZD claims (lending) 122
Non-NZD claims 5
NZ Government securities 7
Claims on RBNZ/notes & coins 1
Other assets 9
LIABILITIES
NZD funding (deposits) 100
Non-NZD funding 28
Capital 8
Other liabilities 7
Source: www.rbnz.govt.nz or RBNZ Financial Statistics
Definitions of money supply
LIABILITIES ($billion at Mar-99)
NZD funding (deposits) 100
Transaction accounts (net*) 12
Other call accounts (net) 27
Other deposits (net) 52
* the netting involves the deduction of inter-institutional deposits and government deposits
Source: www.rbnz.govt.nz or RBNZ Financial Statistics
Monetary Aggregates
Move from narrow to broad definition of money
– as per The Economist, Financial Indicators
M3M1 M2
LIABILITIES ($billion at Mar-99)
$2 billionNZD funding (deposits) 100 notes & coins
held by public
Transaction accounts (net) +12 14 = M1
Other call accounts (net) +27 41 = M2
Other deposits (net) +52 93 = M3
Source: www.rbnz.govt.nz or RBNZ Financial Statistics
Definitions of Money Supply
Money SupplyNote that …….
Unexercised overdrafts– not part of money supply
Debit cards and cheques– not themselves money
Credit cards– accumulate debt to be settled with M1 money
Financial Assets and Liquidity
Money just one asset
Spectrum of liquidity (See Callander, p536)
Cash Physical/human assets
NB liquidity may incur opportunity costs
Liquiditythe ease with which an asset can be converted into an M1 asset (i.e. money ) without loss of capital value
Money Creation
The creation process– bank asset & liability
growth
Limits on natural growth– Daily settlement
– Government does not create money
– Government flows offset
Money and inflation
Money and growth
Where Does Money Come From?
Primitive Bankers– acted as custodians
– issued receipts for gold deposits
– receipts used for transaction purposes
Banking Evolved – bankers made loans (for interest) by issuing
more receipts
– assumed not all holders of deposits would want gold at the same time
reserves only needed to be a fraction of their deposits (liabilities)
Refer Callander2nd Ed p535
Initial Goldsmith’s Balance Sheet
Assets $ Liabilities$
Gold Reserves100
Deposits 100
See Callander, Fig A.2, p538, Balance Sheet A
Goldsmith’s Balance Sheet after Lending
Assets $ Liabilities$
Gold Reserves100
Loans 400
Deposits 500
Compare Callander, Fig A.2, p538, Balance Sheet B
Reserves = 20% of deposits
Fractional Reserve Banking
A banker holds only a fraction of the outstanding deposits in reserve funds
In New Zealand– up to mid 1980’s a system of compulsory
reserve ratios operated (Reserve Ratio)
– ‘Prudential reserve ratios’ are used today
Banking pre-80s
Regulated Reserve Ratios– only replaced in the mid-1980s
Assets $ Liabilities$
Loans
Reserves of Govt. Securities
Deposits
Capital
Banking Today
Self-imposed liquidity management– includes government, bank & corporate
securities
Minimum capital ratios by regulation
Assets $ Liabilities$
Loans
Liquids
Deposits
Capital
Assets $ Liabilities$
Loans
Liquids
Deposits
Capital
Money Creationmore deposits >>> more lending
Often associated with government spending– Gov’t spends money that it does not have
Banks will on-lend (or repay other funding)
Assets $ Liabilities$
Loans
Liquids
Deposits
Capital
Money Creationmore lending >>> more deposits
More likely the cause today– A bank lends money during day (which it may not
have)
– Loan money is deposited in bank
– Loan becomes “self-funding”
Managing Money Growth in NZ
Government issues debt to fund any revenue shortfall (I.e. does not create money)
– Long-term: Government Stock issued monthly (approx.)
– Short-term: Treasury Bills issued weekly
RBNZ also smoothes daily government flows
– through daily and now intra-day settlement
– through open market operations
The Settlement Process
Settlement banks bank with the RBNZ– non-settlement banks bank with settlement banks
At end of day*, the net daily inter-bank flows are known (* next morning actually)
– money owed to other banks paid with RBNZ balances
– i.e. settlement cash
– if bank has no “cash” – tries to borrow from other bank
– can borrow from RBNZ @ 0.25% over cash target
– or +0.30% if rolling intra-day bank bill repo
Refer Callander2nd Ed p473
Smoothing Settlement Cash
RBNZ conduct daily “open market operations” (OMO) to smooth flows
– largely to offset government flows
Too much cash forecast RBNZ sells T-Bills for cash
Not enough cash forecast RBNZ lends cash
– banks borrow cash using Bills and Bonds as security
– actually sell bills/bonds and forward purchase (repo)
Does Money Matter?
Remember week 6 and GDP…
The quantity equationMV = PY
M= stock of money ($)
P= price level ($)
V= velocity of circulation (times per year)
Y= volume of production (number of “things”)
if velocity steady, money growth will match nominal production growth
more money > more output and/or more inflation
Refer:* Sherwin, “Inflation”, Economic Alert, Apr-99
The Output GapLinking money to AD/AS model
More “money” leads to greater aggregate demand
We cannot satisfy all this demand with new products/services
Feeds through to higher prices
AS
Price Level
Real Output
AD AD1
Inflation
Refer Callander2nd Ed p420, Fig 20.6
Money and Inflation
Money and House Prices
-10%
0%
10%
20%
30%
Mar-94 Mar-97 Mar-00 Mar-03 Mar-06
6
9
12
15
18
Source: QVNZ, RBNZ, ASB
Change NZ house price
(left)
Change M3 lending to households (right)
%HOUSE PRICES & HOUSEHOLD DEBT
Summary
Money typically is bank deposits
Can be created from thin air
Growth constrained by capital requirements
– and source of funding
– And by government financing with debt
Also volatility reduced by RBNZ cashflow smoothing
Some loose connection between money and inflation/growth exists
Monetary Policy
Monetary Policy Process
NZ monetary policy a three step process:
1. An inflation target is set by the Reserve Bank Governor (Bollard) & Treasurer (Cullen)
2. An inflation forecast is formed by the RBNZ
3. The RBNZ adjusts short-term interest rates to bring the forecast into line with the target
» via cash rate target
Inflation
In theory, inflation a momentum– the ongoing rise of prices, wages, money supply
In practice, inflation is the change in CPI– goods & services that households consume
– weighted according to proportion of spending
Inflation high late 70s, low now– vicious cycle: higher wages, prices & devaluations
– tried to contain with wage/price freeze early 80s
– eventually moved to independent Reserve Bank
– also tight gov’t control, competitive economy, floating exchange rate
Inflation
“The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices”
Inflation target set for term of Governor’s office
RBNZ actions to be consistent with policy target
RBNZ to consult & advise Gov’t (and others)
Governor-General can set another objective for 12 month periods
Policy statements every 6 months
RBNZ Act 1989 Part II
The Inflation Target
Contract between RBNZ Governor and Treasurer
– Governor appointed to September 2007 Stability agreed to as CPI inflation between 1-3% p.a. on
average over the medium term
Exceptions allowed (if >0.25 was rule of thumb):
– terms of trade shock
– changes to indirect taxes
– natural disaster shock
– changes to government levies
(see Policy Targets Agreement, September 2002)
Consumer Price IndexAs at June 2006
Annual rate 4.0%
– Large contributions from housing & petrol
But inflation?– To what extent
will rises be ongoing?
Tradable vs Non-tradable Inflation
-2
0
2
4
6
Mar-92 Mar-95 Mar-98 Mar-01 Mar-04
-2
0
2
4
6
Tradables
Non-tradables
NZ CPI INFLATION %%
The inflation forecast
RBNZ forecasts inflation
look at annual CPI forecast out 24 months
in RBNZ model, inflation determined by:– exchange rate movements
– international price of exports & imports
– unit labour costs
– output gap
– inflation expectations
influential factors are TWI & unit labour costs
Implementation of Policy
If forecast inflation does not match the target
– then some policy response is required
Policy signalled via interest and exchange rate forecasts
Policy acts through short-term interest rates
Policy is implemented through the official cash rate target
– from 17 March 1999
RBNZ Transmission Path Diagram
Fig 27.3, p490
Forecast annual CPI of 3.9% p.a. (falling to 2.4%)
Cash rate unchanged on the day (7¼%)
Assumes growth slowing
– GDP Mar 04/05 +3.5% to 06/07 +1.1%
“Growth to remain low … headline CPI inflation above 3% well into 2007 … do not expect to tighten … no scope for easing of the OCR this year”
Source: www.rbnz.govt.nz
Current Monetary PolicyRBNZ Jun-06 Projections
No imminent change expected
6.4
6.6
6.8
7.0
7.2
7.4
7.6
Today Dec-06 J un-07 Dec-07
%
As at 21-Aug
Source: ASB
ANTICIPATED 90-DAY BANK BILL (as priced by futures)
Monetary Theory and Practice
General Theory links money growth with
inflation
Correlation between money and nominal output exists in long-run (Quantity equation again)– in short-run, relationship is not evident
Chronic and acute inflation has been associated with money-financed government budget deficits
Monetary Theory and PracticeNZ experience
NZ Government debt-finances
Money growth plays small role
Early 90s fall in inflation coincided with international recession and fiscal tightening
There exist long and uncertain lags between changes to monetary conditions and inflation
Large changes in interest rates are needed to change exchange rates & inflation rates– Low elasticity with respect to interest rates.
Interest Rates
Many interest rates– primary & secondary markets
– wholesale & retail (say <$1m)
Short-term yields (or rates) set in money market where cash, bills and notes are traded
Long-term yields (or rates) set in bond market where bonds, gov’t stock & notes are
traded
90 Day Bank Bill
0
4
8
12
16
20
74 78 82 86 90 94 98 02
NZ 90-DAY BANK BILL(at year end)
Source: ASB Bank
%
Retail Floating Rates
4
6
8
10
12
J an-93 J an-96 J an-99 J an-02 J an-05
4
6
8
10
12
RETAIL FLOATING RATES
Source: ASB
% %
Top Deposit(0-12 months)
Housing
Retail Floating Ratesand Wholesale Rates
4
6
8
10
12
J an-93 J an-96 J an-99 J an-02 J an-05
4
6
8
10
12
FLOATING RATES
Source: ASB
% %
TD(0-12 mths)
ASB Housing
90-day bill
A 90-day bank billwhat is it?
A “bank bill” in NZ now is typically a certificate stating the bank will pay a fixed sum (the face value) to the holder at a set date
– in essence, a tradeable bank deposit
– called a Negotiable Certificate of Deposit (NCD)
More traditionally (and still traded today) a “bank bill” was a Bank Accepted Bill (BAB)
– two parties set up a loan which a bank then endorses
– bank guarantees payment in case of default
A 90-day Bank Billsome characteristics
Returning to Negotiable Certificate of Deposit
– typically issued by banks for 30-180 days
– e.g. bank will pay holder $0.5m in 90-days
– holder can sell to another party if they wish
– banks initially receive market value
Market value of bill determined by bill rate
– NB the rate is a discount rate
– Value = 500,000/(1+rate*90/365)
– e.g. rate=6.0% implies value =$492,710
Major Money Market Instruments
Name Issuer
Treasury Bills Government
Promissory Notes Corporates
Bank Bills Banks
Derivatives linked to Bank Bills:– Futures, Forward Rate Agreements (FRAs)– Options– Interest rate swaps
Fixed Lending Rates
5
6
7
8
9
10
11
12
J an-93 J an-96 J an-99 J an-02 J an-05
5
6
7
8
9
10
11
123 YEAR RATES
Source: ASB
% %
ASB Housing
Major Market Instruments
Securities promising the holder a defined cashflow– Bill (short term)
– e.g. pay $100,000 to holder on 10-Aug-2005– no coupon or interest rate
– Bond (long term) – includes coupon rate as well– e.g. pay $100,000 to holder on 15-5-2010 plus
$3,000 on the 15th of each May & Oct– can get zero coupon bonds
Major Bond Market Instruments
Name Issuer
Government Stock Government
Medium Term Note Corporates/Banks
Bond Corporates/Banks
Derivatives linked to Government Stock:– futures (3yr only)
– options
Wholesale Yield Curve
4
5
6
7
8
9
10
0 30 60 90 120 150 180 270 1 2 3 4 5
31/12/97
31/12/99
<< Days >< Years >>
The Yield CurveDiffering theories
Segmented markets– different people operate in different markets
– rates loosely connected
Expectations– longer-term rates as series of expected short-
term rates
Liquidity or risk premium– premium required to induce people to hold
longer-term investment
Element of all in NZ, strong expectation influence
Interest RatesInfluences
Inflation ( real rate)
Monetary policy
Offshore interest rates
Exchange rate expectations
Extent of borrowing
Next:
– some graphical evidence– some theory
Refer National Bank, Sep 1996
NZ Inflation
0
5
10
15
20
74 78 82 86 90 94 98 02
0
5
10
15
20
NZ CPI INFLATION
Source: Stats NZ, ASB Bank
% %
NZ Inflation & Interest Rates
0
4
8
12
16
20
74 78 82 86 90 94 98 02
0
4
8
12
16
20
NZ INFLATION & 90-DAY BANK BILL
Source: ASB Bank
%
Year End 90-day
%
Year EndCPI
OCR and Other Rates
NZ SHORT-TERM RATES (July 1999 to August 2006)
4
5
6
7
8
9
10
J ul-99 J ul-01 J ul-03 J un-05
4
5
6
7
8
9
10
%
ASB Variable Home Loan
90-day bank bill
Offshore & Local Interest Rates
0
2
4
6
8
10
12
J an-93 J an-96 J an-99 J an-02 J an-05 J an-08
0
2
4
6
8
10
12
90-DAY BANK BILL YIELDS(actual and futures pricing)
% %
NZ
AUS
Long-term Interest Rates
3
4
5
6
7
8
9
10
11
J an-93 J an-96 J an-99 J an-02 J an-05
3
4
5
6
7
8
9
10
11
10YR GOVERNMENT YIELDS% %
NZ
AUS
Interest ratesTheories
Interest rates as a price reflecting decisions about flows
savings = investment
Interest rates as a price reflecting decisions about stocks (I.e. a portfolio decision)
demand for bonds = supply of bonds
These decision processes may be independent!
Interest ratesSavings & investment
People require a positive return to save– i.e. give up current consumption for future
consumption
– savings are expected to rise should rates rise
People willing to pay now to invest– i.e. pay funding cost now in expectation of future
return
– the higher the return, the higher the interest rate
– clouded by ‘return-insensitive investment’
– e.g. government investment
Interest rate a balance of productivity & time preference
The equilibrium interest rateBringing together savings and investment
Interest rate
Amount of savings/investment
Savings
Investment
Refer “How low can they go?” The Economist, 2-Dec-95
The equilibrium interest rateA model of the current account deficit
Interest rate
Amount of savings/investment
Savings
InvestmentRate set low
BOP deficit
Motives for holding bonds– spare cash not needed for transaction
purposes
– as a store of wealth in general
Bond supply– Corporates issues to get cash for investment
– either into physical assets or financial assets
Interest rate a balance of demand and supply for bonds
Interest RatesDemand & supply of bonds
Bond Supply Curve
SUPPLY (borrowers)
Rate of interest
Bond Stock
Bond Demand Curve
DEMAND (lenders)
Rate of interest
Bond Stock
The Equilibrium Interest Rate
Bringing together bond supply and money demand
SUPPLY
Rate of interest
Bond Stock
DEMAND
r
The Equilibrium Interest Rate
Balancing portfolio decisions
Bonds are just one financial asset
Interest rates are also set in other markets– e.g. money market
In general, returns are established in many financial markets
– e.g. share markets
“interest rates” are the result of portfolio decisions
Summary
Interest rates result from the interaction of many decisions
– both about production/saving
– and about asset allocation
In the short-run, RBNZ policy is the major determinant of short-term rates
– longer-term, savings and investment issues will be more influential
Long-term rates are strongly influenced by offshore rates
Banking References
“The banking system in NZ”, Chris Moore, Economic Alert, May 1996
“NZ banks ...”, David Tripe, Massey University, quarterly
Chapter 9 in “Structure & dynamics of NZ industries”, Pickford & Bollard, Dunmore Press, 1988
Chapter in Overview of NZ Economy, NZDMO, see www.treasury.govt.nz/nzefo
“Liberalisation of the financial markets in NZ”, Arthur Grimes, RBNZ Bulletin, December 1998
“Developments in the banking industry”, RBNZ Bulletin, Each June quarter
“Consolidated table of KIS”, RBNZ Bulletin, June 1997
Banking Web Sites
http:// www.rbnz.govt.nz/
http:// www.asbbank.co.nz/
http:// www.anz.co.nz/
http:// www.bnz.co.nz/
http:// www.westpac.co.nz/
http:// www.nationalbank.co.nz/
http://centre-banking-studies.massey.ac.nz/
http://www.kpmg.co.nz/
http://www.bis.org/
Monetary Policy References
Various RBNZ publications– see www.rbnz.govt.nz
Critics of monetary policy– “Prosperity denied”, Bob Jones, Canterbury
University Press, 1996
– Chapter 7 in “The NZ experiment”, Jane Kelsey, Auckland University Press, 1995
Interest Rate Referencesgeneral
“Interest rates and money markets in Australia”, Tom Valentine, Financial Training & Analysis Services, 1991
“The Reuters guide to official interest rates”, Ferris & Jones, Probus Publishing, 1995
“NZ’s money revolution”, Edna Carew, Allen & Unwin, 1987
Reserve Bank Bulletins incl. “An overview of the money and bond markets in NZ”, Sep & Dec 1995.
Some more websites
bloomberg.com
yahoo.com
dismal.com
worldeconomist.com
thepaperboy.com
yardeni.com
imf.org
stats.govt.nz
treasury.govt.nz
Exchange rates
Currency newsletter
For those with an interest in currency markets …
What would you like to read in a weekly currency newsletter?
Email: [email protected]
See www.fxmatters.co.nz
Exchange rate determinantsSome generalisations
in the short-run, high interest rates will lead to a strong currency
in the medium term, large current account deficits will lead to depreciations
in time, low inflation rates will lead to an appreciating currency
Exchange rate volatility
rates are more volatile than fundamentals
fundamentals matter in the long run
– but not in short run
herding as a response to uncertainty
– Refer A Kirman, Bank of England Bulletin, Aug 95
Exchange ratesand interest rates
-1
0
1
2
3
4
5
93 95 96 98 00 02
0.35
0.45
0.55
0.65
0.75
INTEREST RATE DIFFERENCE & NZ DOLLAR
Source: ASB Bank
% USD
NZ-US 90day (left)
USDper NZD(right)
Exchange ratesand inflation
30
50
70
90
110
74 78 82 86 90 94 98 02
0.4
0.6
0.8
1.0
1.2
1.4
US/NZ INFLATION & NZ DOLLAR
Source: ASB Bank
%
Year End NZD(rhs)
USD
US Prices per NZ Prices (lhs)
Exchange ratesand the current account
-16
-12
-8
-4
0
74 78 82 86 90 94 98 02
0.4
0.7
0.9
1.2
1.4
CURRENT ACCOUNT & NZ DOLLARCurrent Account as a % of GDP, NZD/USD at year end
Source: ASB Bank
%
NZD(rhs)
Rate
BOP (lhs)
NZ dollarNZD/AUD & interest rate differential
65
70
75
80
85
90
95
91 93 95 97 99 01 03
-3
-2
-1
0
1
2
3
NZD/AUD & 90-DAY RATES
Source: ASB Bank
cents
NZD/AUD
%
NZ 90-dayless
AUS 90-day
NZ dollarLarge influence of AUD
NZD & AUD
0.45
0.55
0.65
0.75
0.85
93 95 96 98 00 02
0.35
0.45
0.55
0.65
0.75
Source: ASB Bank
USD USD
USD per AUD
USD per NZD
Other currenciesversus the US dollar
EXCHANGE RATE INDICES (versus USD, relative to average 1993-2003 = 100)
60
80
100
120
140
93 95 97 99 01 03
Source: ASB Bank
J PY
NZD
AUD
EUR
US dollar
80
90
100
110
120
130
140
150
70 74 78 82 86 90 94 98 02
-6
-4
-2
0
US DOLLAR & US BOP
Source: ASB Bank
Index
USD Index(left)
%GDP
BOP (right)
Australian dollarFollowing commodity prices
AUD/USD & COMMODITY PRICES, 1983 to 2002
0.45
0.5
0.55
0.6
0.65
0.7
0.75
0.8
0.85
0.9
0.95
Dec-83 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Nov-01
75
80
85
90
95
100
105
110
115
AUD/USD, lhs
CBA Commodity Price Index, rhs
USD INDEX
Australian dollarOr is it?
AUD & CBA AUSTRALIANCOMMODITY PRICE INDEX
60
70
80
90
100
110
120
130
94 95 96 97 98 99 00 01 02 03 04
0.48
0.55
0.62
0.70
0.77
0.85
0.92
0.99
USD
AUD/USD (rhs)
CBA AUSIndex in USD
(lhs)
Sources: CBA, Datastream
USD Index1997=100
NZD AND COMMONWEALTH BANKNZ COMMODITY PRICE INDEX
80
85
90
95
100
105
110
115
120
94 95 96 97 98 99 00 01 02 03 04
0.39
0.43
0.47
0.51
0.55
0.59
0.63
0.67
0.71
USD
NZD/USD(right)
USD Index(left)
Sources: CBA, Datastream
Index1997=100
Index in USD compared with end
of week NZD/USD exchange rate
CurrencySupply and demand
USDPer
NZD
Amount of currency
Supply
Demand
Refer Callander2nd Ed p340
Summary
Exchange rates result from the interaction of many decisions
– both about trading goods and services
– and about investing in assets
In the short-run, interest rates are often the key determinant
– longer-term, any trade imbalance will impact
In NZ, the AUD is a large influence