AUD still exerting restraint

A meme that just will not die at the minute is that the RBA is worried about the recent weakness  of the AUD. I do not think that is correct.

The fact is that the AUD works its way through to consumer prices over a period of years, and the AUD is presently on a multi-year uptrend, in both real and nominal terms. This is clear from the above chart (taken from this Gov Stevens slide-deck).

My research suggests that it takes two to three years for an appreciation of the AUD to fully work its way through to final prices, so it’s only when the currency falls below the three year average that we ought to conclude that there is some inflation ‘in the pipes’ due to AUD weakness.

As the AUD is still going up on the relevant frequency, it follows that it continues to impart a degree of tightening. It is therefore likely to continue to exert some restraint and drive down consumer prices.

So why the fuss? I think folks are focusing too much on the short term volatility of the AUD. It’s down ~10% over the prior few months. The thing about these 10% declines is that they have happened pretty much every year for the last few years – and the AUD’s overall impact has still been to press down on final prices.

Thus, i suspect that it’s not the recent decline that catches the RBA-eye, but the fact that we have been in the present 95/110 range since late 2010.

The focus on the weaker AUD also misses a key subtly when thinking about ‘growth currencies’.  A strengthening AUD may reflect rising   ‘market’ forecasts of global growth, and a weaker AUD may reflect declining global growth expectations.  We need only worry about AUD movements if they are out of step with changes in the growth outlook.

This is the essence of Gov Stevens’ criticism of ‘Monetary Conditions Indices’. If the AUD is weak because export demand is expected to be weak, that’s not stimulatory – and the RBA would not respond to the first round (level shift) in consumer prices that a weaker AUD would result in (due to higher import prices) if the labour market is slack.

Thus, i think Chris is wrong. I doubt that the RBA is worried about the recent moves in the AUD. The AUD continues to trend up in year-average terms (in both nominal and real terms), the recent weakness reflects weaker global growth (both outcomes and expectations), and in any case the nominal exchange rate remains within the range it has traded over prior two years.

This naturally leads to the tradable / non-tradable inflation debate. With the global growth backdrop so weak, i doubt that tradable prices will muster even 1%y/y inflation even if the AUD declines somewhat. Given this, non-tradable inflation of ~3.75%y/y is consistent with overall inflation hitting 2.5%y/y.

Absent a shock, i am quietly confident that core inflation inflation will not exceed the RBA’s 2.5%y/y target over the next two years.  I would guess that they share that view.