Dollar dips and rate cuts go hand in hand

The market is right to be pricing in prospects of further rate cuts in the months ahead, even if the Australian dollar drops below 90 US cents.

There is strong misconception that the recent dip in the Australian dollar will work against the Reserve Bank cutting interest rates again.

There are several reasons why this view is wrong and in fact, the contrary position is true – a weak dollar based on faltering global and softer domestic economic conditions will reinforce the central bank’s resolve to cut interest rates in the months ahead.

Over the past 20 years or so, when the Reserve has implemented easier monetary policy and interest rates are low, the Australian dollar has also been low or falling. The reason? Growth and inflation risks are subdued in these circumstances, which gives the bank freedom to implement easy monetary policy and it sees investors inevitably push the exchange rate lower.

Let’s look back at some examples of the monetary policy easing cycles over the past two decades.

In July 2008, the Australian dollar was trading around 97 US cents. By March 2009, it had fallen to below 65 US cents. Official interest rates around this time of a stunningly sharp currency depreciation were cut from 7.25 per cent to 3 per cent, which was the most severe cut in interest rates ever delivered by the Reserve Bank of Australia. The fall of the dollar did nothing to prevent these aggressive interest rate cuts as the Reserve Bank worked to support domestic demand and simultaneously allow the stimulatory effects of a currency depreciation to work its way through the local economy.

In early 2001, the Australian dollar was trading around 55 US cents and it fell to around 48 US cents by September. During 2001, the Reserve Bank cut the cash rate by 200 basis points, from 6.25 per cent to 4.25 per cent. Again there were no fears about easing monetary policy, even though the Australian dollar had depreciated by 10 per cent to levels never before seen.

In the interest rate easing cycle before that, the Australian dollar was hovering around 77 to 80 US cents in the middle to latter part of 1996 when the central bank first cut interest rates in that cycle. By the middle of 1998, the Australian dollar broke below 60 US cents all the while the Reserve Bank was delivering interest rate cuts – from a cash rate of 7.5 per cent in mid-1996 down to 5 per cent in July 1997 and then 4.75 per cent in December 2008.

See the pattern?

An Australian dollar fall and cuts in official interest rates go hand in hand. A falling dollar does not stop the Reserve Bank of Australia from cutting if and when needed. It never has and never will. 

This is why, until very recently, the Reserve and others were surprised that despite the current rate cutting cycle which starting in late 2011 and there being 200 basis points of rate cuts so far, the Australian dollar was glued at a very high level a few cents above or below 105 US cents.

That was unusual but as has been discussed before (New pressures for the almighty Australian dollar, May 9) and (Why the Aussie dollar is strong as an ox, March 19) the unexpected strength of the currency owed a lot to the triple-A rating of government debt in Australia and the parlous position of sovereign debt ratings in much of the rest of the industrialised world. Money flooded into Australia pushing the dollar higher.

As most market watchers know, market over-valuations or over-shooting can last for a year or more but eventually, markets move back to fair value. The recent drop in the Australian dollar to around 96 US cents and under 74 on the trade weighted index is a step closer to fair value rather than a move towards undervaluation. 

This in itself in another reason why the Reserve Bank will have no fear cutting interest rates again, if circumstances require it. The dollar is still not low, relative to fundamentals.

The key point from those suggesting the Reserve can’t or won’t cut given the dollar has fallen a little in recent weeks is through an impact on imported or tradable prices at a time when domestic inflation is relatively high.

This argument would hold water in a steady state – one where private demand continues growing above 4 per cent as it is now. The issue is that there is a clear slowing in private demand to below 3 per cent in the current year which will see firms face difficulty passing on any price effects from the lower dollar. Domestic inflation will fall and imported inflation rises. This slowing in private demand growth is the very reason the Reserve Bank is cutting interest rates and why further rate cuts are in prospect. 

To be sure, the central bank does take account of the level of the Australian dollar when it considers monetary policy settings, but unless the currency is well away from a level it judges to be fair value, it seldom has a meaningful impact on its policy settings.

This has been the case for the past two decades and it is the case now.

Which is why the market is right to be pricing in the prospects for further interest rate cuts in the months ahead, even if the Australian dollar drops below 90 US cents as now seems likely.