WEEKEND ECONOMIST: Buck stops short

The Reserve Bank board meets next week on Tuesday, July 2. Developments since the June 4 meeting favour unchanged policy. In terms of the statement we anticipate a transparent bias to ease policy further should demand need further support and the inflation outlook provides scope to do so.

Coming as we do from the position that the case for lower rates in the medium term is compelling, every meeting is potentially ‘live’. If policymakers were solely interested in achieving the appropriate level of interest rates over time (i.e. they only acted strategically), July would be a better bet than it is.

In reality, policymakers also wish to gain the maximum traction from each individual move (i.e. they also act tactically). Given that framework, while a move in July would be consistent with the first behavioural condition, it would fail on the second, and thus the following meeting in August remains a more likely window for a rate cut.

We have recounted the arguments regarding the influence that the first quarter national accounts may have on the July Reserve Bank decision previously, and will not repeat ourselves here. Since that time developments in global financial markets have dominated domestic matters, with a dramatic re-shaping of the global yield and exchange rate landscape playing out in anticipation of US Fed ‘tapering’ later in the year.

It is the impact of this large reallocation of global capital on the level of the Australian dollar that has done the most to encourage the re-pricing of the meeting by meeting Reserve Bank rate cut probabilities. With that in mind, we published two separate but related pieces of research this week. The first estimated an up-to-the-minute fair value for the Australian dollar and updated our exchange rate and yield curve forecasts; the second investigated the exchange rate-interest rate trade-off in Australia through the lens of monetary conditions analysis.

The key findings are as follows:

Developments in our Australian dollar forecasts and in its fair value (primary author Huw McKay).

The recent depreciation of the Australian dollar against the US dollar – and in trade weighted terms – has been extremely abrupt. The change in fair value has been somewhat less dramatic. That is due to the fact that the depreciation has had a large exogenous component – a steep reduction in the QE discount priced into US dollar.

That is not to say that there has been no change in Australian dollar specific fundamentals. The Australian dollar’s poor performance on cross rates implies very strongly that there has been. Specifically, we feel that the overall perception of Australia’s cycle position have been altered, and not in a good way; news out of China has been troubling to most observers; commodity prices have not done well; and global yields and ‘risk assets’ have moved sharply. We have recently lowered our expectations for the mid-year peak in bulk commodity prices and the external financing situation has shifted. Each of these factors contributes to our quantitative assessment of the Australian dollar’s fair value against the US dollar.

We estimate that the Australian dollar fair value has declined from US95-96 cents just a few months ago to be around US91-92 cents. Ergo, the currency is trading around its equilibrium value for the first time since late 2011. The extraordinary external financing resilience that the Australian economy exhibited through 2012 had both cyclical (temporary) and secular (permanent) components.

With the cyclical aspects now far less supportive and the rise of the secular factors now mature, it is reasonable to assume that the gap between spot and fair value will not return to the extreme levels seen in 2012; but nor will this premium disappear entirely. As we do not agree with the markets’ current opinion on the timing and scale of any future change in US monetary policy, given our underlying scepticism on the growth outlook, it is our view that a modest premium to fair value will return, and then persist through the forecast horizon. On our projections, fair value through most of 2014 will be about 90 cents.

Therefore, we now forecast the Australian dollar trade to centre on the low to mid US90 cents area next year, from the US96 cents average previously predicted.

The exchange rate-interest rate trade-off and Reserve Bank policy (primary author Justin Smirk).

Despite the rapid rate of decline in the Australian dollar and a significant decrease in the cash rate since late 2011, overall monetary conditions are still between 5 per cent and 7 per cent tighter than long run average.

On this basis, current monetary conditions are still at a contractionary level for overall growth, despite the recent fall in the currency. In other words, the level of the currency still outweighs the impact of rate cuts to date. Therefore, given expansionary monetary conditions would be entirely appropriate, more needs to be done by the policymakers.

Augmenting narrow measures of monetary conditions by introducing the terms of trade into the framework underscores that point. Quite rightly, the bank’s commentary on the currency tends to be couched in terms of its movement relative to changes in export prices. Ignoring the relativity between the real exchange rate and the terms of trade while attempting to ascertain the state of monetary conditions as they pertain to real economic growth would omit vital information. The Australian dollar would have to fall significantly below fair value and sustain that position – consistently outstrip declines in the terms of trade in the current instance – before the 'broad' MCI calculus would be consistent with the Reserve Bank removing their current easing bias regarding interest rates on the basis of the currency alone.

Furthermore, it is debatable whether historical estimates of the correct weight to ascribe to interest rates in the trade-off are still relevant in a phase of passive consumer and active non-mining business deleveraging. If one discounts the weighting on interest rates on this logic, then all other things equal, rates will have to move further to generate the ‘old’ quantum effect on activity. In sum, it becomes clear that the medium-term case for lower interest rates is still very much intact, despite the Australian dollar trading in the low 90 cents area. Therefore, expect the explicit easing bias to be retained in the post meeting statement by the governor.

The market has been right to elevate Reserve Bank tactics over strategy by abandoning July as a rate cut window. However, with between one and two cuts now all that is factored in, the market would do well to revisit their pre tapering views on the medium term strategy best suited to Australia's fundamentals.

Huw McKay is a senior economist at Westpac.