Analysis: Resisting FX Intervention RBA’s Biggest Policy Mistake Last Decade

By Sophia Rodrigues

It was sometime in late-2010, the then U.S. Treasury-Secretary Tim Geithner signalled tolerance for a weak US dollar. Although he later denied it, I always considered that a watershed moment.

For the first time it seemed the issuer of the world’s reserve currency also wanted what every other economy wanted – a weaker exchange rate. But its “want” meant the burden of carrying exchange rate strength fell on other currencies. One such currency was the Australian dollar.

Suddenly the AUD/USD exchange rate equation had changed. It was no longer going to be the  average of what the Australians needed and what the Americans needed. It was going to be more about what the Americans wanted and less of what the Australians needed.

A failure to recognize how deeply this changing equation would hurt Australia, is the Reserve Bank’s biggest policy mistake in the last decade.

And because the RBA didn’t recognize this, it failed to do whatever it could have done to get what Australia needed.

The RBA didn’t even try.

NOT ONE FX INTERVENTION

Not once in the last decade (except one occasion when it directly met demand for Australian dollars) did the RBA use forex intervention to weaken the exchange rate. As a result, the exchange rate stayed too high for too long, slowly leading to loss of Australia’s competitiveness.

Regaining that competitiveness is now Australia’s biggest challenge. And to do that it requires a weaker exchange rate.

On that basis alone, the Australian dollar is still high.

Not high based on fair value. But high because it is higher than what Australia needs.

The RBA has always regarded the exchange rate as a shock absorber for the economy, and in a speech to mark 30 years of floating then-governor Glenn Stevens said the floating exchange rate was “generally speaking, that was good for us.”

Of course, he spoke with the benefit of hindsight because it is difficult to know if a currency is delivering based on what it is doing in the present.

We have the benefit of hindsight now. If we go back and evaluate the Australian dollar level that existed in late 2013 –around $0.90 –I am not sure we can answer in the affirmative that the exchange rate behaved in a way that was beneficial for the economy.

STEVENS DIDN’T ACT ON WORRY

Interestingly, Stevens did have a doubt back then and he did express that doubt. More interestingly his concern was based on what the US dollar was doing and what the Americans needed.

“It’s reasonable enough to worry that it might not (deliver) because in a sense what the Americans need is, you know the pedal’s already on the floor and you know things aren’t working normally. That’s a legitimate enough concern, and that does worry me.”

Stevens’ doubt was legitimate but his biggest mistake was not acting on that doubt by taking a strong action.

On one occasion at a Parliamentary testimony in August 2014, Stevens admitted that he did think about intervention seriously when the exchange rate was much higher but didn’t act on it because the currency subsequently fell.

He said intervention remained a part of the toolkit and would be used if it seems appropriate.

That tool remains untouched in the kit since at least the beginning of last decade.

Instead, the RBA used a milder monetary policy tool to have an impact on the exchange rate. It lowered the cash from 4.75% in 2011 to a record low of 0.75% in late 2019.

The consistent message through most of this period was that the cash rate is lower because the exchange rate is higher.

But a lower cash rate was never going to be enough to put sustained downward pressure on the exchange rate. Maybe intervention was also never going be enough. But we can’t make that judgement now because the RBA never tried.

FLAW IN FAIR VALUE

One reason that RBA didn’t do whatever it could have was because it kept looking at the Australian dollar from the lens of its fair value. But fair value is not fixed because it varies depends on how you measure it. And fair value may not remain fair.

In 2012, the RBA’s preferred measure showed the Australian dollar was 5% overvalued, but based on the range of the estimates, it was anywhere between 4% undervalued or 12% overvalued.

The RBA probably didn’t consider 5% overvaluation a significant misalignment back then and because the focus was on keeping inflation inside the target band, the RBA regarded a high exchange rate as helpful for the economy as a whole.

In reality, however, there was a flaw in comparing the exchange rate to its fair value, because the fair value was based on historical relationships which did not always hold true.

RBA assistant governor Christopher Kent talked about this in a speech in 2014 when he said that it is possible that history that was embodied in the model estimates was a less useful guide for the resources boom because of the changing share of foreign ownership of the resources sector and the large share of LNG projects.

This effectively meant that while the terms of trade was high, its contribution to the economy was not the same as before. So any exchange rate estimate based on the terms of trade would result in a higher fair level, and consequently signal it is not as overvalued as it really is.

The historical relationship based on interest rate differential – another component used in measuring fair value – also didn’t hold true because the U.S. “wanted” a weaker dollar. This meant at any given interest rate differential, the U.S. dollar was going to be weaker than on previous such occasion.

The persistent high exchange rate meant Australian goods and services were expensive to the rest of the world. And offshore goods and services were cheaper for Australians. As a result, the Australian dependence on offshore goods and services kept on increasing.

That dependence continues to hurt Australia even now, and can only be fixed if the country manages to regain its competitiveness. With the cash rate already at a record low level, and not too far away from the lower bound, the only way to be competitive again is to have a weaker exchange rate. .

That weaker level would be lower than the fair value, perhaps even signficantly lower. And if the RBA needs to intervene to make this happen, it should do so.

--Contact: sophia@centralbankintel.com