Aussie dollar hasn’t fallen enough to stop RBA rate cuts…yet

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The Australian dollar has dropped moderately over the past month or so, from around US$1.05 to the US mid-90c range. It naturally begs the question: has the $A dropped by enough to rule out further interest rates declines?

Indeed, will the weaker $A seriously add to inflation and/or quickly restore competiveness to our hard pressed trade exposed sectors?

The answer to most of these question is a resounding no – or at least “not yet”. After all, the $A has only declined by around 8% so far, and still remains well above its average since the mid-1980s of US75c.

Even on a trade-weighted basis, the $A index is about 25% above its long-run average, and almost 50% above “fair-value” on a purchasing power parity basis – or that which align relative cost levels to those of the United States.

Of course, export prices remain relatively high, but even against this benchmark, the $A is also unusually high – as the Reserve Bank (RBA) was keen to stress in this week’s post-meeting policy Statement (at which it left interest rates on hold). So the net effect is that the $A is still hurting competitiveness and imparting a drag on economic growth.

Soft consumer spending

As regards inflation, RBA research suggests the flow through of a weaker currency to consumer prices tends to be quite muted and gradual. Overall, a 10% change in the exchange rate is estimated to produce a 1% change in underlying consumer prices over 3 years, with only one fifth – or 0.2% – of this effect evident after one year. All else constant, that suggests the exchange rate decline to date – if sustained – will boost inflation by less and one quarter of a percentage point over the coming year.

All else, however, is not constant. As also recently noted by the RBA, the price of imported consumer goods has kept falling in recent years even though the $A has been broadly stable – due to improving productivity in retail supply chains and a crimping in profit margins. With consumer spending still fairly subdued, these non-exchange rate forces are likely to continue helping hold down inflation.

More broadly, the softening in the labour market over the past year has already helped slow the rate of wage growth – and with the unemployment rate expected to drift up further, labour cost pressures should also remain a restraining influence on inflation.

Indeed, despite the drop in the exchange rate over the past month, the soft pace of consumer spending and wage growth suggest there’s more downside than upside risk to the RBA’s inflation forecasts over the remainder of this year. Contrary to strong retail sales reports, for example, the national accounts revealed consumer spending only grew a tepid 0.6% in the March quarter and the household saving rate remained at a relatively high 10.6% of disposable income.

At present, the RBA expects annual underlying inflation to hold at 2.25% by the December quarter – or not far from March quarter levels – and there’s a risk it could instead slip a little lower to 2%.

RBA encouragement

Of course, there’s also risk the $A could drop further in coming months, especially if the RBA cut interest rates further. But rather than fearing such a drop, it’s probably what the RBA is hoping for – so much so it may well cut rates further so as to encourage the currency’s decline.

The one counter to this view is if the US economy suddenly gets a lot stronger, such that the Federal Reserve starts to tighten policy more quickly than markets currently expect. This would be a scenario under which the $A could fall ($US rise) even as global growth improves – which would lessen the need for the RBA to cut rates further. At this stage, however, the US economic recovery remains too sluggish to suggest the Fed will take away the punch bowl anytime soon.

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