From BNP research comes their thoughts on the RBA statement last week ...
The biggest surprise from this week's RBA policy decision, arguably, was a more relaxed attitude towards the exchange rate, with reference to its fundamental overvaluation dropped
BNP go on (bolding mine):
- The characterisation of the AUD as being at a "historically high" level was superseded last September, when the RBA ramped up the rhetoric by describing the currency as remaining "above most estimates of its fundamental value". That all changed this week, with the Board dropping any reference to the exchange rate being overvalued and reverting to a comparatively tame observation that further depreciation would be likely given the ongoing declines in key commodity prices. This apparent change in the RBA's assessment of the exchange rate was arguably the biggest surprise to emerge from this week's monetary policy meeting.
- the RBA's shift to a more relaxed stance is an odd one, especially in the light of further falls in iron-ore and coal prices
BNP then ask why the change, saying there are several potential reasons why the RBA sounded more relaxed about the exchange rate (bolding mine):
- In REER terms, the AUD has fallen by around 13% since September, to be roughly in line with levels prevailing in 2004-05.
- In addition, the RBA's internal correspondence indicates that it believed that the estimated 'overvaluation' was within one standard deviation of the trade-weighted exchange rate model's historical deviations. That assessment, however, was made near the beginning of February. Iron ore prices have fallen 25% since then.
- The RBA's inflation mandate may also be a consideration. While falling commodity prices and elevated levels of labour-market slack give the RBA scope to maintain an easing bias at present, a weaker exchange rate inevitably means stronger inflation. Australia's historical inflation record shows two things. The first is that non-tradables inflation is typically sticky at rates below 2.5%. Scope for non-tradables inflation to be sustained below the current rate (of 2.4% in Q4) is thus likely to be limited
- Second, swings in headline inflation tend to be driven by fluctuations in tradables inflation, in turn a function of imported commodity prices and the exchange rate. As the RBA itself observed in its November Statement of Monetary Policy, each 10% depreciation of the exchange rate tends to lift year-on-year headline inflation by 0.5pp for each of the following two years.
- The RBA must thus anticipate a point within its policy horizon at which the weaker exchange rate will manifest as higher inflation. Having indicated this week that lower rates may still be needed, the RBA will not wish to talk down the exchange rate to the extent that it restricts its ability to ease monetary policy.