Talking the dollar down: does jawboning work?

What Federal Reserve nominee Janet Yellen might say will move markets and the Australian dollar - the RBA, not so much. AAP

In a letter to a political ally in 1900, Theodore Roosevelt coined the phrase “Speak softly and carry a big stick; you will go far”. The corollary was that, without a big stick and preparedness to use it, one would go nowhere.

It’s a line that perhaps the Reserve Bank of Australia has been pondering in its comments around the persistently high Australian dollar.

After this month deciding to leave the cash rate unchanged, Governor Glenn Stevens noted the exchange rate was “still uncomfortably high. A lower level of the exchange rate is likely to be needed to achieve balanced growth in the economy.”

At times, the Bank has also signalled its views as to the size of the depreciation required to get back to a balanced growth path. Its November Statement on Monetary Policy opines that “a further depreciation similar in magnitude to that seen earlier this year could be expected to see growth return to trend, or even above trend, sooner than forecast”.

But Roosevelt’s advice also applies to monetary policy. The Reserve Bank has, advisedly, stopped well short of announcing prospective policy changes designed to lower the dollar. For announcements to have any significant effect, markets would need to be convinced that the Bank does, indeed have a big stick.

Such is not presently the case.

Since 1996, the objective of the RBA has been to keep consumer price inflation between 2-3%, on average, over the cycle. What established the credibility of this objective was not its announcement but a track record of achieving it. Having established credibility expectations of inflation don’t move very far outside the target range, especially in the medium term.

Setting the cash rate with an eye on the inflation target and to a lesser extent the level of economic activity leaves little room for intervention in foreign exchange markets, other than to smooth short run disorderly conditions.

Markets know this. They also know that the Reserve Bank and the Australian Prudential Regulation Authority are aware of the risk that lax bank lending standards and rising loan-to-valuation ratios might set off an unsustainable boom in housing prices. The standard policy intervention to lower the exchange rate – a cut in the cash rate and a concomitant expansion in the monetary base– would only increase this risk. But if this risk were controlled by restrictions on bank lending such as caps on loan-to-value ratios (as have recently been implemented in New Zealand) this might give the Reserve Bank more room to manoeuvre.

Even then, monetary expansion on the scale required to shift the exchange rate would have to confront the problem that most of the “high dollar problem” is due to monetary policy in the United States. Markets know that the Reserve Bank is unlikely to intervene while there is uncertainty about the stance of monetary policy in the United States.

Indeed, the policy of the US Federal Reserve provides an interesting example of where announcements of future policy do shift markets.

Faced with a situation where its equivalent of the cash rate cannot be cut any further, the Fed has adopted a policy of quantitative easing. QE itself is just the policy whereby the Fed purchases assets (government bonds) from the private sector, increasing the monetary base.

Because rates are already so low, this has no effect on the current short term interest rate, and the Fed has attempted to gain the use of an additional policy instrument by announcing the terms under which this unconventional policy will be continued.

To the extent that this “forward guidance” works, it is because markets expect future short term interest rates will be kept low by QE, and that keeps current long term interest rates low. As a side effect, forward guidance pushes down the US dollar on foreign exchange markets.

Because they are credible announcements about the path of future policy, any change in forward guidance, particularly as to when QE will be withdrawn, has an effect on longer term rates and on the relative returns on Australian and US bonds. An announcement of “tapering” QE would see the return on US bonds rise relative to Australian bonds, holdings of Australian bonds would become less attractive, and the Australian dollar would fall relative to the US.

Can policy announcements push the Australian dollar down? Yes. But the relevant announcements are those of the Federal Reserve, not the Reserve Bank.