A sharp drop in an overvalued New Zealand dollar that created inflationary pressure would need a monetary policy response, the Reserve Bank says.

The bank has revised up its projections for the local currency on a trade-weighted basis as the kiwi remains in favour against the backdrop of increasingly upbeat global financial markets and a flood of money from major central banks expanding their balance sheets through quantitative easing. 

he RBNZ sees the currency staying above 75 on the TWI until the June quarter next year, having previously seen it falling below 73 by the end of this year.

The TWI dropped to 75.73 after the bank's statement today from 76.21 immediately before it was released.

The strength of the currency has kept a lid on tradable inflation, with the consumers price index is sitting at 0.9 percent, below the central bank's target band of between 1 percent and 3 percent, and giving governor Graeme Wheeler room to keep the official cash rate at a record-low 2.5 percent.

"Exchange rates do eventually adjust in line with underlying economic conditions, often at a rapid pace," the bank says in its March monetary policy statement. "If the exchange rate were to decline rapidly, this would add to inflationary pressures, and monetary policy would need to respond."

The kiwi has climbed to levels that do not match the underlying economic conditions, and those periods can be protracted, the bank says. Some of that strength has been attributed to the central bank's firmer policy stance.

"Though the New Zealand dollar also reflects high terms of trade and recent improvements in market sentiment, the relative performance and outlook of the domestic economy have contributed to New Zealand interest rates being higher than in most trading partners and the New Zealand dollar remaining persistently elevated," the bank says.

The work the currency is doing to keep rates low also holds inflation risks if it stokes greater momentum in the housing market, the bank said. Auckland's bubbling property market, where there is a lack of supply to meet increasing demand, is seen as a growing risk to the nation's financial stability.

Last month, Mr Wheeler told the New Zealand Manufacturers' and Exporters' Association the kiwi dollar is significantly overvalued, and he "will intervene when the circumstances are right".

The RBNZ can intervene in currency markets when the kiwi is at exceptional levels that are not justified, is consistent with monetary policy and when it will work.

The high dollar has become an increasingly heated political issue, with an opposition party inquiry into what it has called a crisis in New Zealand manufacturing, the Labour Party calling for monetary policy to target more than just low inflation and the Green Party arguing the case for quantitative easing, or printing money.

(BusinessDesk)