i j macfarlane : recent influences on the exchange rate speech by mr i j macfarlane, governor of the reserve bank of australia, to ceda annual general meeting dinner, held in melbourne, on 9 november 2000. * * * i am very pleased to have been asked to address ceda ’ s annual general meeting for the third time in melbourne. when deciding on a topic for tonight, i realised that it would be very difficult to discuss the australian economy without spending some time on the exchange rate and the various reasons advanced for its recent fall. so i have decided to plunge in and devote the whole speech to this topic. obviously, we have been doing a lot of thinking about it, and i will see if i can say something useful about it in the 20 minutes i have available tonight. what has happened? the exchange rate has behaved during 2000 in a way that noone predicted. there used to be some elements of predictability for the australian dollar in that its broad movements could usually be explained by changes in our terms of trade ( or its close relative, commodity prices ) and the difference between domestic and foreign interest rates. the relationship was not close on a month - to - month or quarter - to - quarter basis, but it could explain the large swings. this broad relationship is shown in diagram 1 which compares the predicted exchange rate and the actual exchange rate using an equation which has been used in the bank over the years. ( by the way, there is nothing unique about this equation as several of the large banks active in the foreign exchange market have also used a similar formulation. ) what diagram 1 shows is that, on the basis of previous experience during the floating rate period, we could have expected a rise in the exchange rate in 2000. instead, we have seen a fall and the gap between actual and predicted is over three standard deviations - the largest in the past fifteen years. something therefore has changed, at least for the present. diagram 1 real trade - weighted exchange rate index index predicted * actual 1985 - 1999 average * shaded area represents + / - one standard deviation from predicted value. another way of making the same point is to say that the australian dollar has never previously shown a significant fall with economic conditions as they presently are. over the course of 2000, we have had a strong world economy, improving australian terms of trade ( rising commodity prices ), a buoyant domestic economy, a declining current account deficit, a fiscal surplus and rising domestic interest rates. in

the past, a significant fall in the australian dollar has coincided with the opposite - a weak domestic economy and world economy, and falling commodity prices. it has also usually occurred against a background where there has been widespread public criticism of fiscal and monetary policy for being too expansionary. none of these elements is present on this occasion. the comments i have made so far have treated the year as a single development, but i think it is possible to distinguish two phases. for the first seven months or so, the biggest influence on the exchange rate was the expectation of what was going to happen to australian and us interest rates. the predominant view was that the strong us economy would mean that us interest rates would rise more than those in other countries ( including australia ), and this contributed to a strong us dollar and falling australian dollar. any suggestion that the australian economy was weakening ( or the us economy strengthening ) led to a fall in the australian dollar. in the first seven months of the year, virtually all of the large movements in the australian dollar could be explained this way. for example, on two occasions, a weak monthly retail trade figure caused the australian dollar to fall by more than one us cent in a day. our forthcoming statement on monetary policy ( due next monday ) examines this in detail. the irony of this situation was that this process actually involved a misinterpretation of the australian economy. the signs of weakness that were seized upon were anomalies ; the underlying economy remained very strong, incipient inflationary pressures were starting to appear, and during this period our interest rates were raised, as it turned out, more or less by the same amount as those in the united states. nevertheless, the misinterpretation prevailed and the currency fell. over the six months from late january, the australian dollar fell by 11 % against the us dollar and 8 % in trade - weighted terms. the second phase occurred from around mid - year, when it became widely expected by the market that the us economy was going to have a soft landing, and that no further increases in us interest rates were likely. as a result, the market ’ s expectation of future interest differentials moved in a direction favourable to australia. had the foreign exchange market continued to behave as it did in the first half of the year, the australian dollar would have risen, but it did not. it steadied for a while, and then fell appreciably from mid - august. it was this