RDP 9608: Modelling the Australian Exchange Rate, Long Bond Yield and Inflationary Expectations 1. Introduction

More than two decades have passed since the initial relaxation of domestic interest rate controls in Australia and just over one decade since the float of the Australian dollar. Interest rates and exchange rates now constitute two of the most important channels through which macroeconomic policy can affect the broader economy. It is widely recognized that expectations play a critical role in these mechanisms, affecting both the timing and speed with which interest and exchange rates transmit shocks through to real activity and prices. Over the longer run, their influence extends to the efficient allocation of capital and resources. This paper develops empirical models of each of these variables for Australia.

Section 2 begins with a brief review of the exchange rate and bond rate equations in two of Australia's existing macroeconomic models. These large-scale models offer the convenience of an internally-consistent link between these asset price variables and the real economy and typically embody forward-looking financial sector expectations. Their exchange rate and long bond rate equations reflect orthodox theoretical relationships; they are not estimated equations. The textbook-style impulse responses obtained from the macroeconomic modelling of exchange rate and bond rate behaviour offer useful baseline profiles. But the distinctive behaviour of these asset prices, observed in the data in practice, is not fully captured by the macroeconomic model approach. Policymakers need to think more critically about the determinants of these variables since they consititute two of the most important channels of policy transmission. To this end, the remainder of the paper builds on previous work undertaken at the Reserve Bank and the OECD to develop single-equation, behavioural models of the Australian real exchange rate and long bond yield, respectively. In particular, some attention is paid to the role that inflation expectations might play in affecting these two asset prices.

Section 3 builds on the wealth of earlier applied econometric studies of the Australian real exchange rate. This previous literature identifies roles for the terms of trade, net foreign liabilities and long-term interest differentials in determining exchange rate movements. The paper adds, to these factors, direct roles for macroeconomic policy and inflation expectations, which are found to improve the performance of the model.

In contrast, very little work has been undertaken in Australia on modelling the behaviour of long bond rates. Section 4 draws on work undertaken at the OECD by Orr, Edey and Kennedy (1995). This work identifies a comprehensive list of the fundamental determinants of real long-term yields across a 17 country panel data set, including Australia. This paper trials these determinants in a time-series model of the Australian ex ante real long bond rate. This time-series specification suffers several inadequacies and raises the question of how best to transform nominal bond yields into real magnitudes. Because inflation expectations are largely unobservable, the paper spends some time exploring one possible methodology for their measurement.

In practice, inflationary expectations can be heavily conditioned on a country's historical inflation performance. In Australia, successful inflation reduction policies in the early 1990s appear to have been accompanied by falls in existing measured inflationary expectations series. Section 4.2 discusses some inadequacies of these existing measures and estimates an alternative, forward-looking inflationary expectations series. For this purpose, a Markov switching technique is used. This methodology endogenises shifts in the series and produces estimates of the probabilities associated with remaining in particular (high or low) inflationary regimes. A model of the long-term bond yield, deflated with this unconventional forward-looking series, performs quite well. Section 5 concludes.