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Surprise RBA interest rate cut | Is it the exchange rate?

Why has the Reserve Bank moved interest rates to their lowest level in more than 50 years this month?

Daniel Shillito by Daniel Shillito
30-05-2013 09:40
in News
Australian_dollars_money

Australian_dollars_money

WELL forgive us for raising eyebrows, but the unemployment rate actually decreased according to latest data released in Australia, inflation is within the bank’s stated target range, the property market is showing clear signals of buoyancy, and demand for Australia’s commodities (and their prices) are relatively high.

Meanwhile in Europe and the United States governments struggle with austerity measures and unheard of debt levels and cannot do enough (or what is required) to kickstart growth, confidence and somehow tackle high unemployment levels. It’s more than enough to ask — what does the RBA know that everyone else doesn’t? Or, do we simply conclude they are quite pessimistic with respect to Australia’s ability to build growth in non-mining sectors and in the global economy’s eventually negative impact on the Australian economy?

The answer may well lie in a consideration of neither of these viewpoints, but within a new, somewhat narrowed focus upon one key economic variable … Australia’s exchange rate.

The Reserve Bank and the exchange rate

Why would the RBA become obsessed with the exchange rate? Is it their role or mandate to leverage monetary policy with the primary aim to influence Australia’s exchange rate?

Whilst one could argue that economic conditions and in particular inflation rates are benign or stable, especially relative to the major western economies of the world (and hence no need for a rate cut), the Reserve Bank seems to use the same observation to explain how such conditions actually allow the Reserve Bank to focus in on this area.

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An acceptable or lower inflation rate provides scope to lower interest rates since the risk of inflation getting out of hand is reduced. Lower levels of business confidence and an uncertain political climate in Australia could provide some ‘alternative support’ or justification for lowering rates , when viewing overall conditions generally, however the situation could hardly be described by most economists as ‘urgent’.

Hence all but one major economist accurately predicted the rate cut. We might conclude whilst economists were focused on all the usual suspects that influence the RBA’s thinking, perhaps the real and ‘new’ objective this time around is to influence the exchange rate.

Growth trends

In fact the Reserve Bank’s most recent Board minutes stated how global economic growth is only “a little below trend…” and commented on positive growth trends in the US and Asia. It also said financial conditions were accommodative for funding major corporates and sovereign needs, with exceptionally low borrowing costs. Growth in Australia was slightly below trend only most recently and unemployment is still relatively low. In coming to its rate-cut conclusion that there was still “scope to ease further” it highlighted: “The exchange rate, on the other hand, has been little changed at a historically high level over the past 18 months, which is unusual given the decline in export prices and interest rates.”

A depreciating Australian dollar

By lowering rates the bank expects to make the Australian dollar less attractive, at least relatively speaking as an investment or as a safe haven around the world, so as to reduce demand or encourage selling of the dollar, causing a depreciation. Such a result improves our terms of trade, potentially making exports more appealing from a price perspective to international trading partners, and improving the cashflow and performance of Australia’s biggest miners.  Such measures may also encourage more money overall into the stockmarket.

The Reserve Bank knows that steep interest rate cuts (or easing monetary policy) have generally led to a depreciating Aussie dollar in the past — and hence, it knows it can follow this strategy within a low inflation and growth environment, and achieve the desired effect on the dollar.

There’s no doubt a high exchange rate hurts Australia’s export market and Balance of Trade, making other countries more competitive in the industries we export, cutting margins for exporters and making imports more attractive and profitable in many industries.

The fact the dollar has remained stubbornly high through the present rate-cutting cycle probably owes more to the parlous state of sovereign debt ratings in the US and Europe, as opposed to the Aussie mining boom and relatively higher commodity prices and higher interest rates.  However the base level of rates is now at all-time lows, which has to have some effect on the demand for our dollar.

There are risks to this strategy. The impetus a rate cut provides to the housing market by encouraging more borrowing overall, could result in house prices rising at faster than a reasonable rate.  Inflation can rise quite quickly when the flow-on effects of increased borrowing and consumer spending multiply.

However unlike a few years ago, the RBA knows that with increased bank lending margins (profits) and conservative lending practices particularly in business, it has to cut rates harder  for the flow on effect to be felt by the real economy.

The RBA is in completely new territory with record low cash rates, however  it seems the bank has weighed up the current environment and the ongoing risks of a high exchange rate, and concluded that whilst it still can use monetary policy to affect the exchange rate, it’s worth it right now, to do so.

The financial and investment markets, and the economic realities affecting the relative strength of all the world’s major currencies, ought to be allowed to operate in order to find its own level for the Australian dollar, which may well be quite different to long-standing averages or what “it once used to be”.

It’s interesting to note that since the RBA cut rates on 7 May, the Australian dollar has fallen 5 cents against the US dollar, until time of writing.

Banks pass on cuts

Following on from the RBA’s rate cut in May, Australia’s major banks have passed on the variable cut rate in full. Why have they done this? When last time around in December banks did not pass on the cuts and held back more margin for themselves, following communications coming out of banks about the high cost of funds and how the Reserve Bank’s cash-rate changes are not and should not be seen as the primary influencer on their variable mortgage rates.

So, either there are no other significant factors for them to be concerned about this time around, or, as is more likely the case, the banks have seen margin improvement and stability in fact, and are now in a renewed quest for growth in home lending, with levels of overall home lending volumes in Australia only now just starting to recover from extremely low levels. Competition between the majors is now returning and starting to drive greater activity in home lending once again.

Sources: RBA media release 7 May 2013.

Daniel Shillito is a Financial Adviser, CPA and Expat specialist at Aussie Finance and Property Group, qualified both within Australia and throughout Europe. Daniel can be contacted on Ph. 020 3239 0479 or visit www.aussiefpgroup.com

Tags: Australian banksAustralian DollarAustralian economyEuropeexchange ratesExpat Finance: with Daniel ShillitoExpat Lifeexport tradefinanceMoneyReserve Bank of Australiataxtax and financeUnited States
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