Kiwi inflation and the Chuck Norris effect in FX markets

Kiwi inflation and the Chuck Norris effect in FX markets
This is from Bloomberg today:
New Zealand consumer prices rose less than economists forecast last quarter as a strengthening currency makes imports cheaper, adding to signs a period of record-low interest rates will be prolonged. The kiwi (the NZ dollar) fell.
The quote above reminded me about something that puzzled me when I started working in the financial markets. In university I had learned about the Purchasing Power Parity theory (PPP) and that the relative value of currencies is determined by the relative price level, but I soon learned that the real world was slightly more complicated than that. Hence, PPP is telling us that if inflation is lower in New Zealand than in the US then the one should expect the kiwi to strengthen against the dollar. However, as the quote above shows that is not always how the world works. This apparent disconnect between theory (PPP) and reality has led many financial market participants to completely dismiss PPP as something that is not really relevant. That is, however, wrong, but we need to expand our simple PPP theory to also include expectations and a monetary policy rule. The Reserve Bank of New Zealand has a clearly defined and credible 2% (1-3%) inflation target. Hence, if New Zealand inflation drops below 2% then rational investors would expect the RBNZ to ease monetary policy to push inflation back in line with the inflation target. Easing monetary policy (to increase inflation) obviously weakens the New Zealand dollar. This is essentially the RBNZ monetary policy rule - if inflation is below the inflation target the RBNZ will weaken the New Zealand dollar and if inflation is too high then it will engineer a strengthening of the kiwi dollar. I have illustrated that in the graph below. Kiwi PPP MP  



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