10 If financial markets believe that the Bank has abandoned its inflation objectives and is seeking to maintain policy rates at a level consistent with below-target inflation, they will conclude that the easing process is over and proceed to bid the exchange rate up, perhaps substantially so. The TWI exchange rate is already at a high level based on the Bank’s models.
A sizeable appreciation would further squeeze incomes in the tradables sector, and drive tradables inflation lower for longer, thereby lowering overall headline inflation. A significantly higher exchange rate that is not matched by a rise in commodity prices would likely slow economic growth. But it also carries another important risk.