On the RBA’s Australian dollar model

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From Tim Toohey and Andrew Boak:

The RBA today released a paper titled “Modelling the Australian Dollar” which has reinforced the RBA’s preference for a relatively straightforward model of the Australian dollar based on 2 key long-run factors; the goods component of the terms of trade and real short term interest rate spreads in Australia relative to the G3, and 3 short run variables; the VIX, the S&P500 and the CRB commodity index. Although this model is identical to that presented by the RBA via a freedom of information request on 28 January 2014, there are 3 key points of note:

1. The RBA conducted a series of tests for omitted variables and tested for regime change in an attempt to both improve upon periods of unexplained variable in the A$ and the model’s estimated path and to test whether proxies for quantitative easing by other central banks had distorted the level of the A$ in recent years. The RBA found only weak evidence that using proxies for quantitative easing had an influence on the A$. They also found some evidence that the A$ became less sensitive to movement in bulk commodity prices during the commodity price spike and subsequent decline.

2. The RBA conclude that “while the results from these augmented models support the notion that there have been some additional influences on the real exchange rate in recent years, they do not fully account for the behaviour of the exchange rate during the period.” Moreover, despite the wide range of alternative specifications considered, no “single model’s explanatory power is clearly superior to the others, or even to that of the baseline model, over the entire sample period.” In other words, the RBA preferred model remains unchanged although the RBA readily admits it is difficult to “conclude that any estimated level of the exchange rate is the ‘appropriate’ level” and instead policy makers must “inevitably require a degree of judgement”.

3. Using the more updated inputs, we estimate the long-run equilibrium value of the A$ is currently ~6% overvalued using the RBA’s projection for the terms of trade.

Goldman Sachs comment: Although this update on the RBA’s preferred A$ model is unchanged, it is of interest that the model’s current estimate of over valuation is consistent with our 67c A$ forecast on a 6 month view. It is also of interest to contrast our long standing approach to modelling the A$ to that of the RBA (see Australia and NZ Economic Analyst 12/11 “A$ modelling – Capital, credit and central banks”. Since 2002 we have used a similar error correction model approach as currently employed by the RBA and similarly our choice of dependent variable is the real TWI. There are some similarities to our long run model variables. In particular, the terms of trade (whereas the RBA focus on the goods component of the terms of trade) returned a similar coefficient and as shown in our research the historical relationship between the terms of trade and the Australian dollar had not been broken. Indeed, our model showed remarkable stability throughout the estimation period which is key conclusion of today’s RBA paper.

In short, expect a resumption of RBA jawboning as the dollar pushes higher. For future reference, and for the non-egg heads, it’s pretty simple:

6788

The other four drivers are interest rate spreads, growth, sentiment and the relative strength of the US dollar. Voila!

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.