On February 22nd, the Reserve Bank of Australia (RBA) Governor Glenn Stevens spoke with the Australian House of Representatives Standing Committee on Economics. His opening remarks covered familiar ground from the February statement on monetary policy and the February Monetary Policy Decision. As is typical, commentary regarding the Australian dollar (FXA) and its exchange rate most caught my attention. Based on the verbal exchange, this meeting provided more than the usual candor regarding the link between the Australian dollar and interest rate policy, greatly increasing the importance of this meeting.
In his opening statement, Stevens delivered a nice twist by claiming that interest rate policy is not targeting a lower Australian dollar; instead, the RBA has lowered rates to provide a buffer for the potential economic harm from a stubbornly high exchange rate (emphasis mine):
…the exchange rate remains somewhat higher than one might have expected given the decline in export prices so far observed. This has been a relevant factor in the setting of interest rates. It is not that interest rates are seeking a particular exchange rate response, but they are being set with a recognition of the exchange rate's effect on the economy.
The first question for Stevens came from the chair of the committee. She asked why the RBA was so comfortable with rates at historic lows when it was eager to raise them as soon as the emergency of the 2008/2009 financial panic abated. At the time, Stevens cited concerns with creating distortions in the economy. Stevens provided a list of reasons, including pointing the finger at the high exchange rate (remaining quotes and references are from the transcript of the session):
- Households are increasing their savings rate and are much more cautious about taking on debt.
- The boom in resource investment is peaking.
- Fiscal policy is tightening.
- Other major industrial economies have chosen to peg rates extremely low for an extended period of time (presumably pressuring countries like Australia to do the same).
- The exchange rate is high ("…As I have said, I am a bit surprised it has not come down more than it has…the exchange rate is behaving a bit differently.")
Next, a committee member noted that he could not remember an opening statement in which Stevens stated a direct reference to the impact of the Australian dollar. Stevens responded by noting the positive impact on inflation, but "…other things equal there is no doubt that a rise in the exchange rate is contractionary for the economy." Stevens went on to note that all else is not equal, particularly given a "once-in-a-century investment boom with terms of trade 60 or 70 per cent above average." Here is how he explained the RBA's ability to keep interest rates low through this this kind of boom:
The exchange rate…played a role in helping to maintain overall balance in the economy. We do, I think, have this phenomenon that we have not had before of certain types of capital seeking to come to Australia that we would not normally have. I happen to think that the flow into government securities has probably abated in the last eight months - that is what the data say - and much of the capital has been of other kinds.
There are at least grounds to suspect that the Australian dollar is behaving a little differently to some of its behaviour that we have been accustomed to - that matters; that is relevant to the economy. If you were to ask me: is the cash rate therefore a bit lower than it would have been? The answer is yes, I would say. I would not want to try to quantify for you how many points that is but I think we would say that the answer to that is yes.
In other words, the high exchange rate has motivated the RBA to push rates lower than it otherwise would have done. Some (much?) of the blame for this high exchange rate goes to external capital flowing into the country and/or speculating on the currency…and of course, lower rates dampen those flows to some extent.
Another member (Dr. Lowe) of the RBA went much further to paint the specifics on the linkage between interest rates and the exchange rate:
The low interest rates are not specifically designed to try to get the exchange rate to come down but they are offsetting the contractionary effects of the high exchange rate on the economy. We are ending up with this configuration, because exchange rates are relative prices and the Australian economy is doing relatively better than the North Atlantic economies where there is very large money creation going on and very weak economic conditions. Those outcomes mean that their exchange rates are tending to be low. If they are going to be low, someone else has got to be high, and that is us. We are responding to the contractionary effects of that with low interest rates.
So by default, the Australian dollar must be high because it is not creating money and economic conditions are much stronger than North Atlantic countries. Yet, low rates beget low rates: lower rates in an economically weak zone force rates lower in a relatively stronger zone (which in turn likely slows the recovery of the weaker zone). Otherwise, the stronger economy risks experiences a contraction. I was surprised that Australia's major trading partner, China, is not pegged with any blame - perhaps because the Chinese currency is not freely floating.
Stevens confirms that while the RBA believes the Australian dollar is higher than it should be, it is not so high to compel an intervention. In fact, Stevens claimed that sooner or later, the market tends to correct episodes of extreme over-valuation:
…the evidence of history is that, if it is overvalued by a long way, it is going to come down sooner or later and the market will bring it down…The other tool that may be available is, of course, intervention. I think the truth is that, with the power of the forces at work here, you would need to be pretty confident that it is seriously overvalued or that the market is behaving in some quite irrational way before you would launch on large-scale intervention, and we have not done that in this episode. There have been other episodes where we have, but to date, here - as I say, my sense is that it is too high. On the best metrics that I have available to me, it is somewhat too high, but we are not talking 50 per cent or something like that.
Stevens prefers to rely on the markets to set the rate even if they are "irrational much of the time":
I would have to say that, as uncomfortable as it is at the moment, in the broad sweep of history, markets are irrational much of the time, but somehow, over the broad sweep of history, I think they have done a better job setting that price than we would have done if we had been trying to set it. That is not to say they are perfect and it is not to deny that there could be odd things in place at the moment, but, generally speaking, I think the float has served us well and it probably will continue to do so overall.
This meeting provided a few nuggets of new insight regarding the RBA's approach to handling the currency via interest rate policy. Rates are being used to "accommodate" the high exchange rate. Given the RBA's lack of alarm, there is no reason to expect the RBA to get aggressive with rate cuts. In fact, without the emergence of a new crisis, it seems reasonable to expect rates to stay where they are at historic lows. On balance, this seems like a recipe for more drift in the currency.
The current trend for the Australian dollar is actually downward, but it has been a long, slow trek. The Australian dollar has held steady ever since recovering from 2012′s sell-off. For the past two weeks, AUD/USD has repeatedly retested levels where the currency pair closed out 2010 and 2011.
The Australian dollar is trying to hold support at the 2010/2011 closing level
The Australian dollar is very slowly trending downward from the 2011 all-time high
Be careful out there!
Additional disclosure: In forex, I am short AUD/USD.