The minutes of the Reserve Bank board meeting on July 1 provided a mild surprise by not strengthening any of the language around the Australia dollar compared to the June minutes.
The key sentence in the July minutes was: "The exchange rate remained high by historical standards, particularly given the declines in key commodity prices, and was offering less assistance than it otherwise might in achieving balanced growth in the economy".
Contrast that with the observation in the governor's speech on July 3 that "when judged against current and likely future trends in the terms of trade, and Australia's still high costs of production relative to those elsewhere in the world, most measurements would say it is overvalued, and not by just a few cents".
That was indeed strong language and had an impact on the Australian dollar. It fell from US$94.40 to US$93.90 in immediate response to the speech. It was announced shortly after the speech that retail sales in May had fallen by a surprising 0.5 per cent and the April print was revised down to 0.1 per cent from 0.2 per cent. That produced a further fall to US$0.9340.
However, subsequently the Australian dollar rallied back to US$0.9400 – retracing all of the 0.50¢ loss arguably generated by the governor's strong words.
That result is in stark contrast to the Bank's success in 'talking down' the Australian dollar late last year. Recall that following the board meeting of November 5 the Governor described the Australian dollar as "uncomfortably high". At the time the Australian dollar stood at US$0.95.
That strong language supplemented the 'soft' easing bias that had been in place since the rate cut in August. Each set of minutes from August through to December included words to the effect that: "Members [of the board] agreed that the Bank should again neither close off the possibility of reducing rates further nor signal an imminent intention to reduce them".
On its own this 'soft' easing bias did not help in holding down the Australian dollar. When it was first introduced at the August board meeting the Australian dollar was around US$0.89. By the time of the November 5 board meeting the Australian dollar had lifted to US$0.95.
It seems that only the combination of an easing bias and the strong language was successful in bringing down the Australian dollar. From the November board meeting to the February meeting (when the policy combination was abandoned) the Australian dollar had fallen from US$0.95 to US$0.87.
The decision to drop the "uncomfortably high" description and the easing bias following the February board meeting saw the Australian dollar recover back to USD 0.95 by early June.
It seems that a combination of strong language and a preparedness to back it up with policy (easing bias) has been the only effective way to pressure the Australian dollar.
Prior to the November board meeting, the easing bias, on its own, had limited effect. Recently the governor has used strong language, particularly in the speech on July 3, but without a supporting policy change there has been little impact.To be fair, other factors have also been at play.
Low volatility encouraging the 'carry trade' has also supported the Australian dollar. But of course the disappointment for the Reserve Bank since the February board meeting must be further intensified by the 30-per cent fall in the iron ore price since the beginning of the year.
So with strong language not working independently of a policy shift is there any chance that the Governor could revert back to an easing bias?
There may have been a subtle signal on that issue in the July minutes. Language around the rate outlook was modified from "current accommodative stance of policy was likely to be appropriate for some time yet" to "the most prudent course was likely to be a period of stability in interest rates" - arguably an implied shortening of the 'on hold' period. The July minutes also excluded the sentence (used in June): "Those uncertainties were likely to take some time to resolve".
But this subtle change is hardly an easing bias. To gauge this possibility we can look to the reason why the easing bias and strong language was dropped at the February meeting: underlying inflation printed 0.9 per cent in the December quarter, up from 0.65 per cent in the September quarter. The sharp increase was attributed to the fall in the Australian dollar in 2013 – the risk was that further falls in the Australian dollar might jeopardise the inflation strategy.
Based on the Bank's revised inflation forecasts in the February Statement on Monetary Policy we estimate that the Bank expected a print of 0.8 per cent for underlying inflation for the March quarter. It would have been pleasantly surprised with the resulting soft 0.55 per cent.
A very low inflation number for the June quarter, which prints next week, might embolden the Bank to restore its easing bias. After all the market is now pricing in a 60 per cent probability of a 25 basis-point rate cut by early 2015 and consumer spending and housing have lost momentum, largely because of the confidence drag after the federal budget.
We do not think that the inflation print will be low enough to accommodate that change in strategy. We are forecasting a 0.7 per cent increase in underlying inflation for the June quarter. That read would see annual underlying inflation at 2.8 per cent for the year to June – firmly in the upper half of the target range and showing no encouraging downward trend.
The best way to assess the December quarter 0.9 per cent print on the trimmed mean (the preferred measure of underlying inflation), followed by the 0.5 per cent for the March quarter, is that both numbers had some 'noise' and the average quarterly pace of 0.7 per cent is the appropriate way to assess the trend. With the September quarter 2013 also printing 0.7 per cent, the clear message is that underlying inflation is running at a steady annualised pace of 2.8 per cent – up from 2.3 per cent in the previous year and hardly scope for justifying an easing bias.
The Bank's experience with 'talking down' the Australian dollar points to the need to combine an easing bias on policy with strong language. Next week's inflation print is unlikely to accommodate that easing bias. Further attempts by the governor to talk down the Australian dollar without backing it up with policy are likely to prove as unsuccessful as we have seen in the recent past.
Notwithstanding this rather bleak assessment of the success of 'jawboning' policy we do expect the Australian dollar to lose some momentum through 2014 (USD 0.90 target for year's end) in lagged response to the sharp falls in commodity prices in the first half of 2014; some lift in volatility which will discourage carry trades; and around a 5 per cent lift in the USD Index.
Bill Evans is Westpac’s chief economist.