Some important events over the past week have shaped our assessment of the Reserve Bank's current approach to policy.
Recall that in the November Statement on Monetary Policy, the Bank lowered its growth forecast for 2014 from an on-trend 3 per cent to a below-trend 2.5 per cent. The move was even more significant because its previous forecast envisaged growth in the first half of 2014 at 2.5 per cent. The revision was all about the second half – revising the pace down from around 3.5 per cent (comfortably above trend) to 2.5 per cent (below trend).
With monetary policy assessed to act with a lag, the forecast for growth one year out is most important. A below-trend forecast over that period, coupled with a 2.5 per cent inflation forecast, raises the question as to why the Bank is not easing policy immediately.
Of course, that issue might be covered by the decision to maintain the growth forecast at 2.75 per cent–4.25 per cent in 2015 with a mid-point of 3.5 per cent, back to the expected above-trend tempo that was previously envisaged for the second half of 2014.
Of course, just as the lift from 2.5 per cent to 3.5 per cent through 2014 looked ambitious, so too does the new 'lift' between the second half of 2014 and 2015, especially when the drag from the slowdown in mining investment is likely to be larger in 2015 than it will be in 2014. (We estimate –1 percentage point in growth from –0.7 percentage points in 2014.)
The minutes to the last meeting at least recognised this issue, stating: "it was prudent to hold the cash rate steady while continuing to gauge the effects, but not to close off the possibility of reducing it further should that be appropriate to support sustainable growth in economic activity".
However, this theme has now been referred to in the past three minutes and no action has been taken. For now, any urgency to address below-trend growth with interest rates appears to have faded. Instead there is a clear emphasis on the exchange rate. "Members noted that a lower level of the exchange rate would likely be needed to achieve balanced growth in the economy"; "the Australian dollar, while below its level earlier in the year, remained uncomfortably high".
So it was with great anticipation that we attended the governor's speech to the Australian Business Economists' annual dinner on November 22, which was titled "The Australian Dollar – Thirty Years of Floating".
The anticipation was around getting an insight into the Bank's assessment of the degree of overvaluation of the Australian dollar. In that regard, he noted: "It is not surprising that the exchange rate responds to changes in the terms of trade. It is nonetheless striking how close the empirical relationship has turned out to be ... very high terms of trade can be expected to lead to some loss of competitiveness, as noted above. Just how much of this would be expected depends, among other things, on how permanent the terms of trade rise is. But this episode has been very persistent so far".
He concludes: "In the end it is not possible to come to a definitive assessment on the extent of currency misalignment at the moment, on the basis of standard metrics. Having said that, my judgement is that the Australian dollar is currently above levels we would expect to see in the medium term".
Unfortunately he does not commit to explaining whether his medium-term assessment also includes a fall in the terms of trade. He also appropriately refers to the impact of "extraordinary monetary policy measures "in the US, Japan, and the eurozone on the exchange rate. Arguably, the effect of the unwinding of those measures may have already registered with the Australian dollar.
Note that the Australian dollar fell by a net US10¢ since Fed tapering speculation emerged. Even though tapering has now been deferred, the Australian dollar has remained around the level it reached shortly before the "non-tapering" decision was announced on September 19.
The winding down of quantitative easing may already be largely priced into the Australian dollar. The commitment to lowering the dollar was strengthened in the speech by allocating an unusually long passage to intervention. Following the facts on the depth and liquidity of the market for the Australian dollar, which appeared in an earlier part of the speech, that consideration seemed bold.
However, he noted the costs of intervention (negative carry) "would be a price worth paying, if it corrected a seriously misaligned exchange rate". There is nothing in the paper to indicate that the Bank measures the currency to be "seriously misaligned" at current levels.
He bravely continues. "We remain open-ended on the issue. Our position has long been – and remains – that foreign exchange intervention can, when judiciously used in the right circumstances, be effective and useful". Of course, there is another "cost" that is not mentioned that dwarfs the "cost of carry". That is the cost of failure.
In such a deep and liquid market, the Bank would now need to allocate a much larger arsenal than in past interventions to a successful intervention. Failure and the resulting mark to market loss on the newly acquired foreign exchange might prove extremely costly and potentially damaging to the government's budget position. It's hardly a very attractive option for a central bank governor when the "proof" of currency overvaluation is so difficult.
At one stage of the evening, the governor noted that interest rates are at a 50-year low even though growth and inflation are not at 50-year lows. That is because the exchange rate is so high. The clear implication is that if financial conditions are to be eased, then a lower exchange rate is a preferable option.
Presumably, unease with prospective movements in house prices is the source of discomfort in using the interest rate lever any further. In earlier speeches, the governor has indicated that house prices have not moved out of line with incomes. The trajectory of house prices over coming months will be a key determinant as to whether the Bank believes it has some interest rate flexibility. It is our view that the economy will evolve to indicate that further stimulus is required and interest rates are the appropriate instrument.
Bill Evans is Westpac's chief economist.