In the Australian press today, the Australian Financial Review asks Where the RBA’s US85¢ came from? (gated)

It is very rare for central bank officials to mention specific numerical currency targets, but the RBA has become increasingly forthright in trying to talk down the price of the AUD.

So, what 85c?:

published RBA research suggests one of its preferred currency valuation models is based where the currency has tended to trade in the past at given levels of the terms of trade, and at given levels of inflation and real (in other words, after inflation) interest differentials for Australia compared to other major economies

An attempt to replicate the model shows:

the model suggests the nominal Australian dollar has tended to fall over time to offset the fact local inflation has been higher than that in the United States – in other words, the real exchange rate, or index of competitiveness against the US, tends to remain constant over time. … allowing for other factors at work, history suggests the exchange rate adjusts to offset differences in cost competitiveness

the model also suggests that every one percentage point increase in the real interest rate differential between Australia and the United States increases the bilateral exchange rate by 1 per cent, and every 10 per cent rise in the terms of trade increases the exchange rate by 7.5 per cent.
Sure enough, the model suggests that “fair value” for the Australian dollar is currently around US85¢.

  • Due to higher local inflation, for the exchange rate to be back at its long-run average in real terms, it would need to be around US66¢ today
  • The model, however, says the $A should now be 30 per cent above this average real value, due to the fact the terms of trade – even though they have fallen 18 per cent from peak levels in late 2011 – are still 40 per cent above their average since the mid-1980s
  • That would place $A nominal fair value at US85.8¢
  • Then off a cent from fair value because the real interest rate differential is currently around 1 percentage point, or a bit less than its long-run average of 1.7 percentage points
  • the model’s “standard deviation” is around US10¢, suggesting there’s around a two thirds chance the $A will be within US10¢ of fair value at any given time