Please find below an interesting new report from Westpac Institutional Bank discussing the importance of the terms-of-trade and why the currency and/or interest rates would have to fall much further before monetary conditions could be considered accommodative:
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 four-times 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 year-ended 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).
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.
Basically, what Westpac is saying is that as terms-of-trade falls and detracts from income growth, as is currently the case, either interest rates or the exchange rate (or some combination of the two) need to adjust downward.
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness.
Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.
