Board allows itself an international focus

Given the sharp break in the value of the Australian dollar since the last Reserve Bank board meeting there was no expectation that it would cut official interest rates today. Its bias towards cutting further, however, remains.

Since the June meeting of the Reserve Bank board there have been some significant developments, reflected most obviously in the devaluation of the Australian dollar against the US dollar from just under US98 cents to just under US92 cents.

That sharp fall in the dollar was one development within the severe financial market volatility ignited by the US Federal Reserve Board’s foreshadowing of the ‘’tapering’’ of its $US85 billion a month QEIII program of bond and mortgage purchases. Another, noted by the Reserve Bank, was the ‘’noticeable rise in sovereign bond yields from exceptionally low levels’’.

More broadly credit spreads have started to blow out as part of a general unwinding of the multitude of leveraged carry trades that were predicated on the Fed maintaining its quantitative easing program for some considerable period ahead.

Ever since commodity prices tumbled last year the Reserve Bank had been concerned that the dollar remained stubbornly high, maintaining the pressure on the non-resource sectors of the economy even as the resources investment boom was shuddering to a halt.

Even after the steep fall in its value that began in April and accelerated last month the dollar, in the Reserve Bank’s view, remains at a high level. It is hoping that it will depreciate further "which would help foster a rebalancing of growth in the economy’’.

The Australian economy has been growing ‘’a bit below trend", although most of us would say that it has been slowing, with unemployment rising and the manufacturing industry – as Ford’s decision to cease local manufacturing and General Motors’ plea for its employees to take pay cuts if its domestic business is to be maintained – under severe pressure.

Even with the depreciation of the dollar, which should push up the price of imported goods and services, and fuel prices in particular, there have been no signs of inflationary pressures and the Reserve Bank expects the inflation rate to remain within its target range for the next year or two.

The Reserve Bank is holding off on another rate cut in the hope that the lower dollar and the cuts it has already  made, which has lowered the cash rate to an historic low of 2.75 per cent, will generate some rekindling of growth – although it also noted that there was scope for further easing of monetary policy if required.

Given that we’ve yet to see what the impact of the lower dollar might be and that interest rates are already at relatively low levels the Reserve Bank’s decision to sit on its hands again isn’t surprising.

It will want to see whether there are any signs of resurgence in the non-resource sectors as the dollar falls and the resources sector ceases crowding out the rest of the economy before it uses up any of its remaining, diminished, firepower.

With the Fed close to embarking on a gradual winding down of its QEIII program – part of a global response to the financial crisis that has added about $US10 trillion of cheap liquidity to the global financial system – there is, moreover, the potential for another nasty outbreak of instability or worse within the global economy.

While the US shows signs of recovery Europe, for instance, hasn’t used the breathing space provided by a relatively stable environment over the past year to address the structural weaknesses exposed by the crisis nor the interdependencies of the sovereign bonds and banking systems of eurozone members. Yields on European sovereign bonds have risen sharply since the Fed acknowledged that it was about to embark on its next phase of monetary policy.

China is also experiencing some challenges, having had to act in recent days to head off a credit crunch as its new leadership attempts to dampen speculative activity and rebalance their economy towards higher quality and more sustainable growth. Its growth rate does appear to have slowed.

Given the external volatility and risks, and the challenge within the domestic economy of transitioning from the resources investment boom to a different growth model – and the uncertainty as to whether the dollar will continue to weaken and improve the competitiveness and profitability of the more stressed sectors of the economy – it is handy that the Reserve Bank, unlike the central banks of most of the developed economies, retains some significant scope for further rate cuts if necessary.

Most economists, while not expecting a cut today, are factoring more reductions in the cash rate later this year. If that does occur, it won’t be good news.