Policy Perspective

Reserve Bank of Australia

Content but not complacent.

The Reserve Bank of Australia (RBA) left its key policy rate unchanged at 3.50% at todays monetary policy meeting. The key takeaways from todays statement: The Bank has left its concluding paragraph, where it signals policy intent, identical to last month. This would suggest that the Bank does not view the deterioration in the external environment as materially affecting the Australian outlook at this point in time. The Bank has softened its assessment on external demand, noting that the global economy is once again weakening. Regarding China, the Bank notes that growth has moderated to more sustainable levels, but it does not see signs that China is weakening further. The Bank continues to believe that Australian growth is close to trend on most indicators The sequence of earlier decisions is still to impart further support to the economy.

Our assessment: We disagree with the RBA on the first two points and somewhat disagree with them on the third point. Asia and China are weakening by more, and at a faster pace, than the RBA assesses. However, we believe that the Australian economy is growing slightly above trend, and that this will insulate the economy for the time being against a more pronounced external slowdown. We expect the RBA to make no further adjustment to the cash rate this year.

Tuesday August 07, 2012.

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Policy Scenario: Reserve Bank of Australia Monetary Policy Outlook.

Has the RBA invited further portfolio shifts into the AUD?
From a markets perspective, the most interesting aspect of the RBA statement is their dogged refusal to mention the war, ahem, the currency. The charge for the RBA to intervene in foreign exchange markets to weaken the Australian dollar is being led by the academic cohort of the Australian economics community at this time, with market economists more reticent to endorse the return to a dirty float regime.
The AUD loved the fact the RBA wasnt going to erode interest rate support.

Source: Asia Sentry Advisory and Bloomberg.

The AUD clearly loved the fact that the RBA was not taking the indirect approach to weaken the AUD by removing some planks of interest rate support to the currency. Though the positive real level of Australian interest rates certainly contributes to some of the AUD strength, this is not the primary reason for the recent price action in the currency that has been divorced from market fundamentals. The primary reason for the AUD remaining high as traditional drivers wane is the simple fact that the official community is significantly diversifying into the AUD. Significant value investors, such as Warren E. Buffett, have also announced recently that they have purchased the relatively high yielding AUD AAA government debt. And with the one-way appreciation of the AUD and absolutely no indication to date that the RBA has any interest in addressing these portfolio shifts, the AUD-USD still looks like a oneway bet despite a deteriorating global cyclical backdrop. Rather than deteriorating domestic economic fundamentals, it may well prove to be the AUD that could tip the RBAs hand on the policy tiller. The currency is imparting significant damage on the employment-intensive Australian manufacturing sector and a continued appreciation of the AUD despite weakening external demand would be a perverse development that the RBA will eventually need to address, either indirectly via rate cuts or directly via intervention to purchase offsetting reserves equal to the quantifiable portfolio shift now occurring.

Tuesday August 07, 2012.

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Policy Scenario: Reserve Bank of Australia Monetary Policy Outlook.

How the RBAs policy announcement has evolved?

The most important points we identify in the evolution of the RBAs thinking from July to August are: The Bank has softened its assessment of external demand, however, it believes that China has moderated to a more sustainable pace and does not appear to be slowing further. The Bank barely mentions the AUD which many academic economists believe is significantly overvalued given portfolio shifts in the official sector. The Bank has not altered its concluding paragraph, where it signals future policy intentions, one iota. The Bank, therefore, appears to be content with the support current monetary policy settings are offering the economy. The comparison of the July and August policy announcements are provided below. Red strikeout = deleted Red underline = New content Black = Unchanged content

JulyAugust Policy Outcome Statement by Glenn Stevens, Governor: Monetary Policy Decision At its meeting today, the Board decided to leave the cash rate unchanged at 3.50 per cent. Growth in the world economy picked up in the early months of 2012, having slowed in the second half of 2011. But more recent indicators continue to suggest weakening in Europe and a slower pace of growth in China.Having picked up in the early months of 2012, growth in the world economy has since softened. Current assessments are that global GDP will grow at no more than average pace in 2012. Most commodity prices have declined, which has helped to reduce inflation and provided scope for some countries to ease macroeconomic policies. Australia's terms of trade peaked nearly a year ago, though they remain historically high. China's growth has moderated to a more sustainable pace, but does not appear to be slowing further. Conditions in other parts of Asia have recovered from the effects of last year's natural disasters, butthough the ongoing trend is unclear and could be dampened by the effects of slower growth outside the region. The United States continues to grow at a modest pace. Commodity prices have declined, which is helping to reduce inflation and providing scope for some countries to ease macroeconomic policies. Australia's terms of trade have peaked, though they remain historically high.Growth in the United States continues, but at only a modest pace. The most significant area of weakness continues to be Europe, where economic activity has been contracting and policymakers confront the very difficult task of seeking to put both bank and sovereign balance sheets onto a sound footing, while promoting conditions for improved long-term growth. Financial markets have initially responded positively to signs of further progress towards longer-term sustainability in European financial affairs, but Europe will remain a potential source of adverse shocks for some time. While capital markets remain open to

Tuesday August 07, 2012.

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Policy Scenario: Reserve Bank of Australia Monetary Policy Outlook.

corporations and well-rated banks, lowLow appetite for risk has seen long-term interest rates faced by highly rated sovereigns, including Australia, decline to exceptionally low levels. Share markets have remained volatile.Nonetheless, capital markets remain open to corporations and well-rated banks and Australian banks have had no difficulty accessing funding, including on an unsecured basis. Share markets have remained volatile, though in net terms they have generally risen over the past couple of months. In Australia, recent data most indicators suggest that the economy continuedgrowth close to grow in the first part of 2012, at a pace somewhat stronger than had been earlier indicated. trend overall. Labour market conditions also firmed a little, notwithstanding data show moderate employment growth, even with job shedding in some industries;, and the rate of unemployment has thus far remained low. Inflation remains low. There have been no changes to the , with underlying measures near 2 per cent over the year to June, and headline CPI inflation lower than that. The effects of the price on carbon will start to affect these measures over the next couple of quarters. The Bank's assessment of the outlook for inflation. Over the coming one to two years, and abstracting from the effects of the carbon price, inflation is unchanged: it is expected to be consistent with the target. over the next one to two years. Maintaining low inflation over the longer term will, however, require growth in domestic costs to slowcontinue their recent moderation as the effects of the earlier exchange rate appreciation wane. InterestAs a result of the sequence of earlier decisions, monetary policy is easier than it was for most of 2011, with interest rates for borrowers have declined, to be a little below their medium-term averages. BusinessWhile it is too soon to see the full impact of those changes, dwelling prices have firmed a little over the past couple of months, and business credit has increased more strongly in recent months, though credit growth remains modest overall. The housing market remains subdued. The exchange rate has been volatile recently, but overall remains high. As a result of the sequence of earlier decisions, there has been a material easing in monetary policy over the past six months. recorded its strongest growth for several years. The exchange rate, however, has remained high, despite the observed decline in the terms of trade and the weaker global outlook. At today's meeting, the Board judged that, with inflation expected to be consistent with the target and growth close to trend, but with a more subdued international outlook than was the case a few months ago, the stance of monetary policy remained appropriate.

Tuesday August 07, 2012.

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Policy Scenario: Reserve Bank of Australia Monetary Policy Outlook.

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