Falling like feathered ninepins now. From Bloxo today:
Driving a car with a broken shock absorber can be quite an unpleasant experience. Every bump in the road can be felt. For Australia’s economy, its key absorber of global economic shocks has been the AUD. Without large ups and downs in the AUD in recent years, Australia’s economy would not have dealt as easily with the commodities boom or the global financial crisis. But, in a world where central banks continue to use unconventional policy, the AUD may not be the same shock absorber it once was. This issue has once again come to the fore. In the face of recent declines in iron ore prices, the AUD has remained stubbornly high. If this divergence persists, it could frustrate the RBA’s efforts to rebalance growth, which could see rates needing to be lower for longer. If the shock absorber is not working, get ready for a bumpier ride.
In the past, the AUD has played a major role in protecting the Australian economy from international shocks. When the commodity prices boom was ramping up, the AUD appreciated to very high levels (USD1.10 at its peak in 2011) to help the economy absorb a strong positive shock to its incomes without excessive inflation. This worked through a number of channels. As resource exports are largely priced in USD terms, the rise in the AUD helped to reduce the impact of the positive income shock on the domestic economy (in AUD terms). The very high AUD also slowed down the non-mining sectors by encouraging more imports, including tourism services, with Australian’s travelling abroad in record numbers and doing more of their discretionary retail spending overseas at the same time.
Working in the other direction, when the global financial crisis struck, the AUD fell very sharply (US61 cents at its trough in 2008), which provided support for the economy. Exporters became more competitive, miners’ profits were supported (in AUD terms), Australians’ took fewer trips abroad and spent more locally (rather than on goods and services from overseas) and imports fell sharply, boosting domestic demand.
The RBA see the AUD as the key price that acts to help the Australian economy adjust to global shocks. This leaves them to adjust the cash rate to, in large part, deal with the domestic cycle. While this is an over-simplification, as interest rate settings affect the level of the AUD (through interest rate differentials) and the AUD also affects local conditions, it is, nonetheless, a useful way to think about the roles of the exchange rate and the cash rate.
As the RBA’s own preferred model of the AUD shows, the vast majority of the medium-term historical variation in the AUD can be explained by changes in the terms of trade (read: commodity prices which are determined globally) whereas the interest differential plays a lesser role in determining the AUD. In the medium-term the AUD seems to have played its role as a global shock absorber quite well, given its strong positive correlation with the terms of trade.
The RBA should be quite happy with the role its cash rate setting is playing at the moment. The historically low cash rate setting is already delivering the sorts of effects that might be expected. The housing market is booming, approvals for housing construction have risen and retail sales have been picking up. The lift in the interest-rate sensitive sectors appears to also be driving a pick-up in hiring intentions, such that the unemployment rate has actually fallen in the past couple of months. There would be little reason, at this point, for the RBA to consider cutting rates further, given that low interest rates are having the desired effect. Further cuts could also create risks, if lower rates were to lead to over-inflation of the housing market. Thus, they have a ‘neutral bias’ and we retain our long held view that the easing phase is done.
But the AUD is not moving to support local growth. Indeed, the price of Australia’s major export, iron ore, is currently USD100, having fallen by -25% since the beginning of the year. At the same time, the AUD has risen by +5% to US93.5 cents since the beginning of the year. The further the iron ore price falls without a corresponding fall in the AUD, the more pressure this puts on local income growth (in AUD terms).
This leaves the RBA with a challenge. The low cash rate is doing what it should do — supporting a domestic upswing — but the AUD is not playing its traditional role as a shock absorber. This could reflect a range of factors, including Australia’s own domestic turnaround, the Federal Reserve’s recent dovishness, the likelihood that the ECB will deliver further stimulus next month and the Bank of Japan’s ongoing asset purchase programme. In a low interest rate world, Australia’s higher interest rates and triple-A sovereign rating look attractive.
Last year, the RBA addressed this challenge by trying to ‘jawbone’ the AUD lower. Speeches and statements were used to point out that they expected the AUD to fall and that its level was ‘uncomfortably high’. The RBA has been reluctant to do this in recent months. In our view, this reluctance reflects that there is now more convincing evidence that growth is rebalancing away from mining to the non-mining sectors, such that there is less urgency to loosen financial conditions. Also, last year the RBA was able to argue that the Federal Reserve’s asset purchase programme was clearly distorting currency markets, which is less easily done now that they are tapering. Keep in mind, the USD cross rate is the single most important exchange rate for Australia, given its key role in pricing commodities.
Of course, the RBA could once again choose to start jawboning the AUD lower, if the divergence between commodities and the AUD continues or the RBA starts to get more nervous about the recent slowing in China. But, we see the likelihood that the RBA would consider cutting rates further as very low, given the domestic economy is lifting. Without an easing bias it may also be harder for the RBA to credibly jawbone the AUD lower.
With the AUD at its current level or higher, there is a clear downside risk to our current central case for the RBA to start to lift the cash rate around year-end (Q4). Indeed, watching the AUD over coming months will be of critical importance for determining the timing of the RBA’s next move. A higher AUD, particularly in the face of falling commodity prices, is likely to slow the process of rebalancing growth and help to put downward pressure on inflation, which could see the RBA keeping its cash rate lower for longer.
Full report here…
