The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Sunday, May 1, 2011

Updated: What should the RBA do about the Aussie dollar?

In short, nothing. Indeed, the RBA should arguably place even less weight on the Aussie dollar than it appears to be currently doing. The logic is actually very straightforward when you think through it. Put yourself in the shoes of the RBA Board, or more importantly, the RBA's three most influential decision-makers, Glenn Stevens, Ric Battellino, and Phil Lowe:

1/ Can we control the currency? Absolutely not. The AUD/USD exchange rate is as much determined by US policy as domestic decisions. The trade-weighted index, which reflects Australia’s currency relative to the currencies of our major trading partners, falls into exactly the same camp.

2/ Can we forecast the currency? No. The RBA has made it clear that it does not believe that anyone can accurately forecast the currency, or at least precisely enough to predicate policy on.

3/ Can we therefore assume that the currency is "doing some of the work" of monetary policy (as is claimed by almost all economists and the media), or can be used as a subsidiary tool of monetary policy? Absolutely not. You cannot control it, and you cannot reliably forecast it. Who forecast the Aussie dollar at 1.10 US cents in April 2011? Nobody I know of. The currency could just as easily fall 10-20 per cent in the next few months if US interest rates rise, or if there is some shock to commodity prices. More worryingly for the RBA, the currency is probably more likely to fall than rise over its two year forecast horizon.

4/ The RBA is a "risk manager", which is a point often lost on economists and the market. The RBA has one job: to keep inflation between the 2-3 per cent pa swimming lanes. The RBA does not get bonuses for higher economic growth, or lower unemployment. Unlike the Treasury, the RBA is not a policymaking engine. Nobody gets prizes for coming up with smart ideas about industry policy. The RBA's payoff function is simple: it is reputationally rewarded if inflation remains within its formal target band over the long run, and punished if it does not. What is the punishment? Rising consumer inflation expectations. This then feeds back into ‘cost of living claims’ (via wages), and back into prices again. Hence the RBA's chief fear of a wage-price spiral, which could eviscerate its entire policymaking model. And this fear is all the more germane given the Government’s submission to the Fair Work Commission that minimum wage changes should encompass cost of living pressures. This means that the RBA will not be able to simply ignore some of the headline inflation numbers, as many economists hope.

5/ Very few people seem to understand the way the RBA thinks. The RBA's executive has a long institutional memory. They work in decades. They know that in the late 1980s the RBA's monetary policy model--the so-called ‘check-list’ approach--broke down. They know that RBA’s new model—known as ‘inflation targeting’--got a free ride during the 1990s and early 2000s via a combination of the huge amounts of spare capacity left in the economy after the acute 1990-92 recession, and once-off microeconomic reforms (some of which are being reversed). This was evidenced by the decade and a half decline in unemployment without inducing inflation pressures. They know that their current inflation-targeting framework is unproven if one takes a multi-generation view. Moreover, they know that Australian inflation-targeting failed its first major test prior to the GFC, when core inflation spiked to beyond four per cent per annum. And they know that if the RBA does not pass its next test, the entire monetary policy edifice could be placed at risk (note that this may not be the probabilistic "base case", but it is a terrifying risk nonetheless). That means the bank's credibility, and the executive's life work.

6/ So, taking all of the above, the RBA is setting interest rates today with a two year forecast horizon in mind. It needs to assume a currency path over that period. If the RBA is a risk manager, that currency path needs to be conservative. Thus, any sustained appreciation in the currency is actually a bonus/benefit for the inflation-targeting central bank. In setting policy, the RBA has to assume quite the converse. It has to (conservatively) suppose that the currency is actually an inflation risk, through, say, a rise in US interest rates after the Federal Reserve ceases its program of buying US Government bonds (to drive down yields) in June this year. This is the only sensible approach a risk-focussed policymaker can take given the probabilities available to us today (ie, a nontrivial chance that the currency has overshot).

7/ A final word on RBA psychology. Economists and investors make the mistake of worrying about weak household demand, weak GDP, weak business surveys, etc. This logic is faulty. The facts are that the RBA has missed its core inflation target by a sizeable 0.50 percentage points per annum for over a decade. It is currently missing its core inflation target by a near 1.0 percentage point per annum based on the first quarter CPI data released last week. This is prior to the commencement of the biggest investment boom in Australian history. This is at a point when the labour market is already fully employed. If the RBA is to have any hope of achieving its inflation goals, it needs--as I have long argued--to pre-emptively engineer sub-trend economic growth and sub-trend employment growth today well in advance of the pending capital expenditure boom. It needs to create spare capacity before the terms of trade shock flows through to the real economy. It actually ideally wants to undershoot its inflation target by some margin at this point in the cycle.

8/ This also speaks to my other long-held thesis: the RBA has an asymmetric response function: All other things being equal, the RBA would probably prefer to undershoot than overshoot its inflation target (especially given its deteriorating historical track-record). Taking this view of the world, solid labour growth, a falling unemployment rate, robust business conditions/confidence surveys, healthy wages growth, and trend economic growth are actually bad news for Australia's central bank. An extremely high core inflation print in the first quarter of this year is a potentially catastrophic portent. If the RBA was to exercise the decision of least-regret, it would hike interest rates on Tuesday. As Governor Glenn Stevens regularly remarks, if you wait until you are absolutely certain you have to hike rates (eg, after we get the second quarter inflation numbers in August), you are almost certainly too late.

Of course, the RBA will do everything possible to convey the impression that it has got these issues under control. What else can it do? To panic would only exacerbate the problem. No, right now they need a great deal of headmasterly conviction that they are going to wallop the economy if required to thrust inflation back into the swimming lanes. To hesitate is to court calamity.