QE inaction throws spanner in our works

The clouds over our economy got a bit darker this week with the news that the US Federal Reserve was in no hurry to begin "tapering" its quantitative easing. This underlined the reality now dawning on the new Abbott government that the outlook for the economy is quite uncertain and, unless we're lucky, quite weak. It's certainly not a time when you should shift to a contractionary stance of fiscal policy because of some misguided desire to force the pace in getting the budget back to surplus.

But let's start with the Americans and their quantitative easing. "QE" is a form of economic stimulus - the sort you resort to when you can't stimulate the economy the conventional way by cutting the official interest rate because it's already close to zero.

It involves the central bank buying government bonds or other securities in the marketplace and paying for them by just crediting money to the sellers' bank accounts (a trick only central banks, the creators of money, can do).

The intention is that increasing the money in circulation encourages demand (spending) at a time when aggregate (economy-wide) supply exceeds aggregate demand, with workers lying idle and firms operating well below full capacity.

Some people, remembering stuff their heard in the 1970s and '80s, worry that "printing money" causes inflation. It does if it causes demand to exceed supply - as would have been the case back then - but it doesn't when demand is a lot weaker than supply, as has been the case in the North Atlantic economies since the global financial crisis.

Even so, the Fed has been warning it will start cutting back (tapering) the amount of its continuing monthly purchases of bonds as it sees the economy strengthening, just to be on the safe side.

What happened this week was the Fed's decision that the economy wasn't yet strong enough to start the tapering. It was worried that recent figures for employment weren't as strong as expected.

It was also aware that the congressional deadlock over the budget was bringing about cuts in government spending and increases in taxes that exerted significant contractionary pressure on the economy. And another confidence-sapping battle between the President and Congress was brewing.

So how do our interests fit into this? Well, this is where it gets tricky. It's not bad news that, in the face of a weaker-than-expected economy, the Fed decided not to start withdrawing monetary stimulus. It's in our interests for the US economy to be as strong as possible.

What is bad news is that the US economy isn't strong enough for the tapering to begin. That's because one of the ways quantitative easing stimulates demand is by putting downward pressure on the country's exchange rate.

And anything that puts downward pressure on an important currency like the US dollar puts upward pressure on our dollar. What's stimulatory for them is thus contractionary for us.

As we've been reminded only too well in recent years, a high dollar reduces the international price competitiveness of our export and import-competing industries, causing us to produce less than we otherwise would.

From our perspective, our dollar has been high because of the resources boom: the high prices we were getting for our exports of mineral and energy and because of the foreign capital flowing in to finance all the investment in new mines and natural gas facilities.

With export prices having fallen a fair bit over the past two years, we expected to see our dollar come down and stimulate production in manufacturing and tourism.

For a long time nothing happened. It started falling in mid-April, but still hasn't fallen as far as it probably should given the size of the fall in export prices.

It took us too long to realise what the problem was: quantitative easing in other countries, particularly the US. Our dollar couldn't come down because it was being held up by the weak greenback.

This is a reminder that the exchange rate is a relative price: the value of our currency relative to the value of some other country's currency. So it's affected both by developments in our economy and developments in theirs.

It was when the Fed started making noises about tapering its quantitative easing that the currency market began anticipating this occurrence, pushing the greenback up and allowing our dollar to fall. Between mid-April and the end of July the Aussie had fallen about 14 per cent.

But this week's surprise announcement from the Fed saw the greenback drop against most currencies, including ours. Last time I checked, the fall since mid-April had narrowed to 10 per cent.

It's always dangerous to assume some change of direction that's just happened in financial markets will continue or even just not be reversed. But this week's events do suggest that the further fall in the Aussie dollar we've been hoping for is now less likely because the phasing out of America's quantitative easing is now further away.

Our present problem is familiar to you: with the resources boom's net contribution to growth now turning negative, we need the rest of the economy - particularly investment in new housing, and non-mining business investment - to take up the running. A decent fall in the dollar would do a lot to help stimulate the non-mining economy.

The other hope is for a turnaround in business and consumer confidence following the change of government.

The main indicators of confidence have improved since the election, with the Westpac-Melbourne Institute index of consumer sentiment jumping 4.7 per cent this month as Coalition voters' confidence leapt 19 per cent and Labor voters' fell 10 per cent.

But it's far too soon to say whether this improvement in the indicators of business and consumer confidence will translate into a significant improvement in actual economic activity and employment.