Rates must fall to put lid on the dollar

The professional punters may be divided about which direction the Reserve Bank will jump today, but there are 107 good reasons why our central bank should cut interest rates again. All relate to the strength of the Aussie dollar.

The professional punters may be divided about which direction the Reserve Bank will jump today, but there are 107 good reasons why our central bank should cut interest rates again. All relate to the strength of the Aussie dollar.

Let's explore just a few of them.

Late last year, when our central bank began shaving interest rates, it was swayed by the potential for chaos on global markets and the need to soften monetary policy settings just in case the worst eventuated.

But it was a close call, particularly the December cut.

According to the minutes from its December 6 meeting, the domestic economy was chugging along nicely and our major trading partners were shipshape. On that basis, alone, it considered there was no need to cut rates of 4.5 per cent, which it considered just about right.

It cut them anyway, to 4.25 per cent, as the storm clouds gathered over Europe.

Many would argue now that there is less reason to cut rates again. In the two months since the last meeting, the perception is that the danger levels have receded. Wall Street has resumed its march northwards, to its highest level since 2008, employment in the US has just experienced its first solid jump in years, and the Europeans appear to be muddling through their debt crisis.

Despite the appearance of a more benign climate in the developed world, credit conditions on global markets remain tight. While there has been some easing in the past six weeks on European debt instruments, bond traders are far more nervous than their cousins in the equity markets.

If you need to bet on which is correct, it is always wise to opt for the guys in control of the money instead of those selling the stocks.

This morning, the debate is likely shift more to domestic factors, which have begun to overshadow global events, dominated by the strength of the local currency and the impact it is having on the economy.

With a once-in-a-generation resources boom in full swing and continued growth in China and our other Asian trading partners, the dollar can head only upwards.

The Aussie dollar will be stronger for longer. There is no doubt about that. And that strength will provide the mechanism to reshape the economy, squeezing investment out of industries that can no longer compete.

But there is good reason to believe it has been pushed to artificially inflated levels by the manipulation of both American and European central banks that have slashed their interest settings to just above zero in an effort to drive their currencies lower.

At 4.25 per cent, our interest rates are at a huge premium to almost every other developed nation. Throw in a triple-A credit rating, and the Aussie dollar - once considered the peso of the Pacific - suddenly has been transformed into Popeye. What not so long ago was among the world's most volatile currencies suddenly has achieved safe haven status.

Everyone wants a slice of the action. And who can blame them? Borrow euro, buy Aussie. It's a no brainer.

Add to the equation the fundamental reason our dollar is strong - the vast inflow of investment funds to build and expand resource projects coupled with record shipments of raw materials - and reining in the Aussie will be no easy task.

But narrowing that interest rate differential with Europe, the US - and by association China - and Japan, may go some way to achieving it.

The threat of inflation, which dominated discussion around the Reserve Bank boardroom last year, clearly has receded.

The most recent official figures showed an annual rate of 3.1 per cent for the December quarter. More importantly, underlying inflation - the RBA's preferred measure - was sitting at about 2.6 per cent. That's well within the 2 to 3 per cent targeted range.

Job creation also has stalled as the currency strength cut a swath through import-competing industries, forcing many to sack workers.

While the headline unemployment rate, at 5.2 per cent, was among the best in the developed world, job growth was the worst since the Bureau of Statistics began compiling the figures in 1992.

Add to that yesterday's consumer spending numbers. Retail remains weak, so weak in fact that in the lead-up to Christmas, it contracted from even the paltry levels of December 2010.

Annual retail sales grew by just 2.4 per cent last year, down from a 2.5 per cent rise the previous year. That was the weakest growth rate in 27 years. And again, that record only exists because 1984 was the year the bureau began compiling the statistics.

If the Reserve Bank needs any further convincing, it will come this week as the half-yearly profit season cranks into gear. The universal thinking is that this year will be tough.

Sharply lower commodity prices will make it nigh on impossible for our resources giants to continue their run of record earnings. Interestingly, those lower commodity prices have failed to show up in the dollar, which until 18 months ago, was a barometer for raw material prices.

The stellar run from our major banks also is likely to come to a halt. A reduced appetite to borrow and spend has prompted consumers instead to reduce debt. Corporate lending has been slow and about the only avenue available to boost profits has been to reduce costs by sacking staff and fattening margins by refusing to pass on official rate cuts.

And corporations with foreign operations also will struggle under the yoke of a strong dollar. This year, they'll be repatriating a lot less cash after conversion.

It will be a tough call this morning and no doubt a vigorous debate. But the Reserve has not just the latitude, but every reason for a third rate cut in as many meetings.

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