A relentless Aussie dollar defies the RBA

Sinking terms of trade and a shrinking resources investment pipeline mean this month's rate cut was a near certainty. But the dollar's refusal to reflect the change in outlook is the big concern.

After the recent slew of weak economic statistics and the abrupt emergence of an increasingly grim outlook within the recently booming resource sector it was a near certainty that the Reserve Bank would cut the cash rate this month, and it did.

Last month’s RBA statement was tinged with careful optimism about the global outlook, a slight concern about inflation and an expectation that the 1.5 per cent reduction in official interest rates in the current cycle would put a floor under the housing market and flow through to stronger growth in consumer confidence and spending. On Tuesday the RBA governor, Glenn Stevens, made some modest but significant departures from that script after the bank’s December board meeting.

The bank has added a rider to its continuing view that modest growth is occurring in the US, referring to "uncertainty over the course of US fiscal policy," which is a reference to the still-approaching "fiscal cliff." Otherwise its view of the rest of the world, where risks remain on the "downside," hasn’t changed much, although where last month there were expectations for progress in Europe, today Europe "is likely to remain a source of instability for some time."

Where the terms of trade had declined by 13 per cent from the peak in November they are now down 15 per cent and where a month ago the bank thought the peak in resources investment would probably be reached next year now it says merely that recent data confirms it is approaching. (Some would say at a disconcerting rate, with question marks emerging even over some projects that were thought to be locked too firmly into the investment pipeline to be pulled out).

Last month’s concerns over inflation – the RBA noted then that recent outcomes (inflated by the introduction of the carbon tax) had been slightly higher than expected – have receded and inflation levels are now consistent, it says, with the medium-term target.

While Stevens said there were signs of easier conditions starting to have some of the expected effects, the fact that the bank cut the cash rate by 25 basis points to 3 per cent says either that the effects are minimal or that it doubts their sustainability. Certainly no-one in the real economy appears to be claiming much joy from more than a year of falling interest rates.

It is significant that the rate cut takes the cash rate back to where it was at the low-point of the last cycle, between April and September 2009. That was, of course, in the immediate aftermath of the global financial crisis and during a period where central banks, and governments, were taking emergency measures to protect and stimulate their economies.

There is something perverse about rates now falling back to that level within what is supposedly one of the world’s most strongly-performing economies, although those comparisons are, of course, relative. The rest of the world still isn’t in good shape and the low rates then were accompanied by the Rudd government’s decision to throw everything, including the kitchen sink, at a desperate attempt to put a floor under the economy. With bank funding costs higher than they were pre-crisis, the rates that count – those charged to borrowers – are also higher than they were in 2009.

The real concern for the RBA and Wayne Swan ought to be, not just the fact that the terms of trade are sinking in the wake of fallen commodity prices, nor even that the once-remarkable resources investment pipeline is now shrinking on an almost daily basis, but that the exchange rate isn’t reflecting the change in outlook.

The pressure on the rest of the economy created by the resource boom may be abating but the strength of the dollar, buoyed by central bank buying and a continuing (if reducing) positive spread relative to other sovereign yields, is muffling the benefits from the investments that were made, under-mining the investment cases for projects yet to be green-lighted and continuing to hollow out the non-resource side of the economy.

If it remains strong relative to our trading partners even as the levels of resources investment peak and then fall away there’ll be a nasty crunch point for the economy to deal with unless governments do something, quite urgently, to improve the economic fundamentals.

Given the extent of caution within the community, whether within businesses or households, the 25 basis points is unlikely to spark any meaningful uplift in activity. It would be interesting to know whether there was any discussion today about a 50 basis point cut.

Of some significance will be whether the banks pass on the full 25 basis points to borrowers.

While funding cost pressures on the banks appear to have eased, all the major banks are pursuing aggressive attempts to attract and retain deposits, particularly retail deposits, to reduce their reliance on wholesale funding.

There have been signs that the surge in their deposits is tapering, which a rate cut won’t help. There might be a temptation to shave something off the 25 basis points that could flow to housing loan rates to soften the impact on depositors, which wouldn’t do much to help lift activity levels within the economy.

In the absence of an emerging the RBA board won’t meet again until February, after the critical Christmas season for retailers has passed. Given the way the economic indicators have been turning down again, it appears unlikely that even the rate cut is going to make this a Christmas to be remembered fondly.

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