OPINION: RBA Forecasts With a Different Exchange Rate Path. That’s a First!

By Sophia Rodrigues

Call it more transparency or a sign of things to come but it was interesting how for the first time ever, the Reserve Bank of Australia gave an insight into what its quarterly forecasts for the economy would look like with a different assumption on the exchange rate.

And it was comforting to note that a 5% fall in the exchange rate would get trimmed mean inflation closer to the mid-point of the target band by the end of forecast period.

In the latest Statement on Monetary Policy (SoMP) published on November 9, the RBA used its MARTIN model to show the effect on staff forecasts from a sustained 5% depreciation in the exchange rate. RBA always uses assumption of an “unchanged” exchange rate in the staff forecasts.

MARTIN stands for MAcroeconomic Relationships for Targeting Inflation. It is a full-system macroeconomic model of the Australian economy that has been a key tool used to conduct scenario analysis at the RBA. RBA staff also use MARTIN to show forecasts beyond the usual two-to-three year forecasts published in the SoMP.

The model retained all the other assumptions that the RBA staff made in producing the forecasts for inflation, unemployment rate and growth in the policy statement. This included among other things, an assumption of cash rate tracking market pricing, and unchanged oil price.

The model showed that a 5% lower exchange rate would lead to GDP growth being roughly half a percentage point higher than in the central forecasts over the forecast period.

The model also showed the unemployment would drop by 0.4 percentage points to 4.5% by the end of 2021 and trimmed mean inflation would rise by 0.3 percentage points to 2.25%.

The RBA first started publishing forecasts for growth and inflation in the February 2008 SoMP, and only in the last couple of years, it has added unemployment rate to the forecasts. Prior to February 2008, for one year the RBA used to publish just inflation forecasts.

Right from the start, the RBA always assumed a constant exchange rate which was the prevailing exchange rate while publishing forecasts.

RBNZ ALWAYS USES DIFFERENT PATH FOR EXCHANGE RATE

The RBA’s methodology is in stark contrast to the Reserve Bank of New Zealand which assumes a different exchange rate path while drawing forecasts.

It may surprise some to note that RBNZ has been publishing forecasts since 1997, and right from the start it has made assumptions on the exchange rate path which was different to the prevailing exchange rate.

The RBA could probably take a cue from the RBNZ and start publishing forecasts with a different assumption on the exchange rate. This would create more transparency and guide market pricing for central bank action when the exchange rate follows a different path.

All things being equal, it would mean a lower cash rate if the actual exchange rate is higher than the assumption. In the current circumstances, it would raise probability of Quantitative Easing.

Or both – lower cash rate and QE.

--Contact: sophia@centralbankintel.com