Bulletin

28 June 2013

Australian monetary conditions update The exchange rate interest rate trade-off

The Australian dollar has fallen sharply recently - and not

just against the US dollar. The AUD's depreciation has been essentially across the board. Given the importance of the currency in recent monetary policy deliberations, a cut at the July window (which we never favoured over August regardless) looks to be extremely unlikely.
1.15 1.05 0.95 0.85 0.75 0.65 0.55

Australian dollar falls from the high

USD
AUD/USD (rhs)

USD

1.15 1.05 0.95 0.85 0.75 0.65 0.55

This does not, however, mean that the RBA is set to

remove their current easing bias. A formal method for considering such questions is to construct monetary conditions indices, essentially an effort to quantify the trade-off between the exchange rate and interest rates. Such 'MCIs' assign weights to specific financial variables according to their ability to explain real economy developments.

Sources: Bloomberg, Westpac Economics

0.45 Jun-83

0.45 Jun-89 Jun-95 Jun-01 Jun-07 Jun-13

The simplest form of MCI only takes into account the

real exchange rate and real interest rates. 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 the rate cuts to date.

Commodity prices & AUD

470 420 370 320 270 220 170 120 70 Jun 90 Jun 95 Jun 00 Jun 05 Jun 10 0.7 0.6 0.5 US$ index
Sources: ABS, Bloomberg, Westpac Economics

More sophisticated MCIs add extra variables to this core

formulation, such as equity prices, quality spreads and the like. Our favourite augmentation when looking at Australia is to introduce the Terms of Trade (ToT). As the ToT is an important variable in explaining the real exchange rate (real trade weighted index or real TWI), the relative contribution of the two is what really matters for overall conditions. In fact, RBA research suggests the ToT's impact on the economy may be almost four time larger than that of the real TWI. Ignore the ToT at your peril.

USD 1.1 1.0 0.9 0.8

commodity prices (lhs) AUD/USD (rhs)

We have thus incorporated the ToT into our preferred MCI

and we believe the resulting indicator helps to explain Australia's strong performance from 2004 to 2008, when rising rates and an appreciating currency resulted in very tight 'narrow' monetary conditions, but the economy forged ahead regardless. Looking ahead, we estimate that current monetary conditions are still tight and, as such, the RBA will retain an easing bias at the July meeting.

Real trade weighted index 8% fall in Q2

180 160 140 120 100
Sources: RBA, ABS, Westpac.

The AUD would have to fall significantly below fair value,

i.e. more than what the underlying fundamentals suggest it should, and stay there for a sustained period, before the 'broad' MCI calculus would be consistent with the RBA removing their current easing bias on the basis of the currency alone. Furthermore, it is debatable whether historical estimates of the correct weight for interest rates are still relevant in a phase of passive consumer and active non-mining business deleveraging. If one discounts this impact somewhat, it becomes clear that the mediumterm case for lower interest rates is still very much intact, despite AUD/USD trading in the low 90 area. Detailed analysis continues overleaf.

index
real TWI

index

180 160 140 120 100

80 80 Dec-85 Dec-89 Dec-93 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

28 June 2013
The Australia dollar has fallen sharply against the USD and most other major currencies over the last few months. Westpac's estimate of the June observation of the RBA's real TWI (inflation adjusted effective exchange rate, hereafter RER) is 8% below its March quarter 2013 post-float high. Surely a falling AUD reduces the pressure on the RBA to cut rates? To answer this question robustly, a framework for quantifying the impact of the exchange rate on the economy, in a general context, is required. To get some guidance on the relationship between the currency, interest rates and the stance of monetary policy, the traditional approach is to construct a monetary conditions index (MCI). The form of the index is generally defined as:

Australian monetary conditions index

120 115 110 105 100 95
Sources: RBA, ABS, Westpac.

index

%yr

120 115 110 105 100 95

MCI (real cash rate + real exchange rate)

MCI = 100 + (real cash ratet - real cash rate(base period))

+ c/r*(RERt - RER(base period)) Where:

90 90 Dec-85 Dec-89 Dec-93 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13

100 is to index the MCI to the base period. The real cash rate is the cash rate less underlying inflation. RER is the RBA's real trade weighted index of the AUD. The ratio c/r is the trade off between the RER and the real
cash rate.
87

The MCI is still contractionary.

index
MCI inverted (cash rate lhs) average MCI since inflation targeting output gap (rhs)

%
Sources: RBA, ABS, Westpac.

3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0

If you assume that both a higher real interest rate and a higher real exchange rate will drag on economic activity, then the coefficients c (for cash) and r (for RER) should both be negative. The ratio c/r will thus be positive, implying that an increase in the MCI represents more restrictive monetary conditions, and vice versa. From here on, this formulation will be referred to as the 'narrow' MCI. Most analysts using narrow MCIs ascertain the value of c/r from empirical studies that estimate specific coefficients for the key variables within a general framework. These estimates centre on 1:3 and 1:4. That is, a 3-4% move in the RER has the same impact on the volume of economic activity as a 1ppt change in the real cash rate in the same direction.1 On this basis, the recent fall in the RER would translate into a 3% fall in the narrow MCI (or a 3% fall from its Q2 2012 high). So, yes the fall in the currency means that monetary conditions are relatively easier than they were. But just how easy in an absolute sense is open to debate. The index is still 5% above its average level since the start of inflation targeting in 1993. So, based on this formulation, even with the low level of the real cash rate, the sustained high value of the currency is still generating a restrictive stance in monetary conditions and is thus still exerting a contractionary influence on real economic activity. In looking to augment the narrow MCI, the first point to note is that private sector borrowing rates are not wholly determined by the RBA policy rate. To take this into account, we can substitute the average discounted variable mortgage rate for the cash rate. This version of the MCI is more than 7% above its average since 1993, arguing that monetary conditions are even tighter than the narrow MCI formulation would imply. The simple conclusion from the above analysis is that narrow monetary conditions are clearly still contractionary, being somewhere between 5% and 7% above average depending upon the measure of interest rates used. The second augmentation is the big one. We now introduce the elephant in the room: the Terms of Trade (ToT).

91 95 99 103 107 111 115 Jun-90

Jun-94

Jun-98

Jun-02

Jun-06

Jun-10

Using mortgage rates paints a tighter picture

87 91 95 99 103 107 111 115 Jun-90 index
MCI inverted (mortgage rate lhs) long run average MCI output gap (rhs)

%
Source: RBA, ABS, Westpac.

2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0

Jun-94

Jun-98

Jun-02

Jun-06

Jun-10

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

28 June 2013
There is a broad acceptance that the ToT is a very important variable in explaining the level and direction of the real exchange rate. In fact, the RBA's preferred RER fair value model, as described in documents released under the Freedom of Information Act earlier this year, specified that the real exchange rate is a function of the ToT and the G3 interest rate differential (Reserve Bank email "The Australian Dollar model results" Dec 14, 2012). So, if the ToT is a key determinant of the real exchange rate, ignoring the relativity between the RER and the ToT while attempting to ascertain the state of monetary conditions as they pertain to real economic growth would omit vital information. Further, highlighting the importance of the ToT for the Australian economy, RBA research estimates that the coefficient for the ToT in their small model of the Australian economy is around fourtimes larger than that for the RER; so, a 20% rise in the RER is needed to offset a 5% ToT gain (RBA Research Discussion Paper "A small model of the Australian macroeconomy: An update" 2005-11). Using the RBA analysis from that paper to choose an appropriate coefficient, we have constructed a 'broad' index that incorporates the real mortgage rate, the real exchange rate and the (through the year) change in the ToT. It is not strictly a MCI, but we feel that there is far more information content in this formulation than in the narrow version. We'll call it the 'broad' MCI hereafter. This broad MCI is highly instructive. Firstly, where the standard MCI struggles to explain why growth was so strong from 2004 to 2008 (when a rising currency and higher interest rates were producing very tight narrow monetary conditions), the broad MCI captures the strong growth in the ToT, suggesting that narrow monetary conditions were actually quite loose given the scale of the positive income shock the economy was enjoying. It also highlights that the recovery phase after the GFC slowdown was (to a large extent) explained by a rebound in the ToT from the 2009 low, as well as the associated rate cuts. In contrast, the 2012 decline in the ToT (still impacting yearended growth) swamps the 2013 decline in the AUD. So, while the broad MCI has eased a little, it is still almost 7% above (remember, higher index, tighter conditions) the average level since 1993. And compared to the Sept 2010 low point (i.e. historically stimulatory settings), it is 22% higher. All told, while the fall in the AUD has helped ease monetary conditions, the improvement has been relatively marginal. In a recent bulletin, we concluded that the fair value of the AUD had declined, but that the currency had not fallen below that mark. Specifically, "We estimate that AUD/USD fair value has declined ... to be around 91-92. Ergo, the currency is trading around its equilibrium value for the first time since late 2011."
(Huw McKay "AUD fair value update" June 26, 2013)

Terms of Trade and the real TWI

220 200 180 160 140 120 100 80 60
Sources: RBA, ABS, Westpac.

index
ToT (lhs) real TWI (rhs)

index 170 150 130 110 90 70

40 Jun-86 Jun-90 Jun-94 Jun-98 Jun-02 Jun-06 Jun-10

The fall in the ToT matters for policy

81 87 93 99 105 111 117 Jun-90 Jun-94 Jun-98 Jun-02
Sources: RBA, ABS, Westpac

index
MCI inverted (with ToT %tty lhs) long run average MCI output gap (rhs)

2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5

Jun-06

Jun-10

Note 1. In what is now a quite dated research article, Stone, Wheatley and Wilkinson (RBA Research Discussion Paper "A small model of the Australian macroeconomy: An update" 2005-11) calculated that the tradeoff between the real cash rate and the real exchange rate was 1:18 over the long term. That is, a sustained 18% change in the real exchange rate has the same effect on real activity as a sustained 1ppt change in the real cash rate. It is important to use this analysis with care as it based on a permanent shock to the cash rate and exchange rate and incorporates the response of all the variables, including inflation, to that shock. But it is worth highlighting that the Bank's analysis also shows that the real exchange rate has a more immediate impact on activity than the real cash rate. Nevertheless, if you use a 1:18 ratio in an MCI you effectively end up with a real cash rate index. For our purposes, we are happy with the old rule of thumb of a 1:4 ratio.

Clearly, given the importance of the terms of trade, we would argue that the AUD would have to fall meaningfully below fair value (and stay there) to alter the RBA's current easing bias. This is not our expectation for the foreseeable future. From here, as long as the AUD reacts to changes in its fair value (i.e. ToT and relative interest rates), then its overall impact on monetary conditions will be relatively neutral, allowing the Bank to focus its attention on boosting interest rate sensitive activity, as it must given the job and capex-rich phase of the mining boom is receding. Justin Smirk, Senior Economist, ph (612) 8254 9336 (with contributions from the Westpac Economics team)

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

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