REPEAT:MNI ANALYSIS:RBA Fcast Dilemma Due Hike Pricing, AUD

Repeats Story Initially Transmitted at 03:20 GMT Jul 28/23:20 EST Jul 27

--Could RBA Revert to Constant Cash Rate Assumption in Forecasts?

--Change in RBA Language on AUD a Possibility

By Sophia Rodrigues

     SYDNEY (MNI) - For the first time since May 2011, the Reserve Bank of

Australia is facing the prospect of incorporating significantly tighter monetary

conditions from both an elevated exchange rate and market pricing for a cash

rate hike into its new economic projections. 

     The combination of the two could hurt the chances for the RBA to keep its

growth and inflation forecasts little changed versus its previous projections in

May, forecasts that economists and market are bracing for. By incorporating

tighter monetary conditions into its forecasts, the RBA risks validating current

pricing and even encouraging the market to price in greater odds of a near-term

rate hike and thus put further upward pressure on the exchange rate.

     The market reaction could be relatively benign if the factors underlying

the new forecasts were seen to offset each other, with a downgrade in the

forecasts due to tighter monetary conditions taken as a dovish signal. But a

scenario where the RBA maintains its projections despite the higher exchange

rate and market pricing for a hike could be damaging for the economy because it

could push the currency higher.

     The RBA's cash rate decision is due Tuesday and three days later it will

publish its quarterly Statement on Monetary Policy, which will contain updated

forecasts and commentary on the economy. Those forecasts are made available for

discussion for Tuesday's cash rate decision and most economists expect the RBA

to retain the forecasts issued in May.

     In the last quarterly forecasts published in May, the RBA assumed the

then-prevailing Australian dollar exchange rate at $0.74 to the U.S. dollar and

a trade-weighted exchange rate at 64. Following the acceleration in the

Australian dollar in recent weeks, it is currently trading around $0.795 against

the greenback and around 67.5 on a trade-weighted basis. Assuming no significant

change in these levels next week, the RBA would have to factor in an almost 7%

appreciation in the Australian dollar vs USD and 5.5% on a TWI basis into its

new forecasts.

     In May, the market priced in a 10-basis-point hike in the cash rate

one-year ahead (June 2018), which the RBA assumed in its forecasts. But this

time market pricing has doubled to 20bps by August 2018. And, unlike in May when

the offset came from a lower exchange rate -- it stood at $0.76 and 66 on TWI --

this time the exchange rate is higher, too, and hence there's more tightening to

factor in.

     And the rise in mortgage rates for some borrowers in recent months adds

another source of domestic tightening.

     The RBA has always assumed the current exchange rate level in its forecasts

but it has not been rigid about factoring in market pricing for the cash rate. 

     The last time the market was pricing in a cash rate hike and the RBA

incorporated that assumption in its forecasts was May 2011. In August that year,

the RBA switched to assuming the prevailing cash rate for the entire forecast

period. In February 2015, it again reverted to assuming market pricing and has

been making such assumption since then.

     Back in August 2008, the RBA took the unusual step of assuming a constant

cash rate but also incorporated the effect of the tightening in credit markets

and rise in mortgages rates, which were around 60 basis points more than the

cash rate. "There has been some additional contractionary effect from tighter

lending standards and reduced access to capital markets, as well as from the

decline in equity markets," the RBA said then.

     In November 2008, the RBA took into account some reduction in bank deposit

and lending rates following the government guarantees of liabilities, while

assuming an unchanged cash rate.

     Given the flexibility that the RBA has retained while making assumptions in

the past, it has the opportunity to revert to an unchanged cash rate assumption

for the new forecasts. While any such assumption is never meant to represent a

commitment by the Reserve Bank Board to any particular path for policy, the

market would still interpret it as a signal of "on hold for longer," a message

the RBA has consistently conveyed recently.

     That would be helpful in putting downward pressure on the Australian

dollar, at least as far as pressure from expectations of tighter domestic

monetary policy is concerned.

     The RBA also has an opportunity to jawbone the currency lower by changing

its language on the exchange rate. For over a year now, the RBA has been saying

that a lower exchange rate has been assisting the economy's rebalancing but an

appreciating exchange rate could complicate this.

     It could revert to a language last used in the April 2015 cash rate

statement when it said "A lower exchange rate is likely to be needed to achieve

balanced growth in the economy."

     Such a statement could put some downward pressure on the exchange rate. 

     However, a more desirable outcome for the currency and interest rates from

the RBA's point of view would be a combination of jawboning and an explicit

suggestion that the cash rate will "on hold for longer" by reverting to a

constant cash rate assumption in its forecasts.

--MNI Sydney Bureau; tel: +61 2-9716-5467; email: sophia.rodrigues@marketnews.com