IT'S not at all clear that falling commodity prices or the Reserve Bank's latest cut in the official interest rate will lead to a lower Aussie dollar. But if it doesn't fall, and the economy doesn't look like it will stay growing at its trend rate, the Reserve will just keep cutting rates.
The best way to think of the Reserve's problem in using monetary policy (interest rates) to maintain non-inflationary growth is that for some years it's been trying to keep the economy on an even keel while we're being hit by two powerful, but opposing economic shocks: the expansionary shock from the resources boom and the contractionary shock from its accompanying very high exchange rate.
This involves predicting, then continuously monitoring the relative strengths of the opposing forces, with the objective of keeping inflation in the 2 to 3 per cent range and the economy growing at about its medium-term trend rate of 3.25 per cent a year neither much less than that nor much more (because the economy's already close to full employment).
For most of last year the Reserve's greatest worry was that the stimulus from the resources boom, applied to an economy already near full employment, would push up inflation. By November it realised any inflation threat had passed it was actually falling whereas growth was on the weak side of trend. It therefore cut the cash rate by 125 basis points (1.25 percentage points) between November and June.
The latest reassessment of the balance between the two conflicting forces bearing on the economy is that the fall in coal and iron ore prices and the shelving of expansion plans by some second-tier miners will cause mining investment spending to peak in the middle of next year, a little earlier and a little lower than expected.
This pushed the growth forecast for the overall economy a bit below trend. Hence this month's rate cut.
It's reasonable to attribute the Aussie's remarkable strength since the start of the resources boom predominantly to our high commodity export prices and vastly improved terms of trade.
That makes it reasonable to expect the fall in export prices would lead to a commensurate fall in the Aussie, thus reducing its contractionary effect on our export and import-competing industries.
But the historical correlation between our terms of trade and our exchange rate, while strong, can also be quite loose for fairly long periods. So it's not surprising the Aussie has held up so well.
The plain truth is that, because financial markets simply aren't as "efficient" as it suits some economists to believe, no theory they can come up with adequately and always explains the Aussie's ups and downs.
The best you can say is the terms-of-trade theory works well a lot of the time and over the medium to long term, while its main rival that the Aussie's driven by the size of the "differential" between our interest rates and those on offer in the big economies sometimes works at other times.
So it's equally unsurprising the 150-basis-point fall in our official interest rate since November has done little or nothing to get the Aussie down.
My guess is the Aussie could stay much where it is for years to come. Why? Because of a third, omnibus theory: those countries with the best growth prospects tend to have strong exchange rates whereas those with poor prospects tend to have weak exchange rates.
It's a safe bet that, even if we were to fail in our attempt to get growth back up to trend, our prospects will stay a mighty lot better than those for the United States and Europe. Then there's our AAA sovereign credit rating and exposure to the fastest-growing region, Asia, to entice capital inflows.
Remember, exchange rates are relative prices, so if some countries are down, others must be up. We're not alone in the strong-currency boat: there's also Switzerland, Canada, New Zealand and Sweden.
So, what if the Aussie stays up and its contractionary effect on the economy remains undiminished? The Reserve would just keep cutting the official rate until it foresaw growth getting back up to trend.
In principle, the only thing that could deter it from this response is rising inflation pressure, but with growth below trend that's hardly likely.
Its goal wouldn't be to get the dollar down (though that would be welcome) so much as to stimulate the presently ailing, interest-sensitive parts of the domestic economy: home building and commercial (as opposed to mining-related) construction.
This would quite possibly get house prices growing reasonably strongly which, in turn, could perk up consumer confidence, particularly for people in or near retirement.
But that's actually the vulnerability in such an approach by the Reserve. Returning to a period of exceptionally low mortgage interest rates risks igniting another credit-fuelled boom in property prices, at a time when many households remain heavily indebted and most foreign economists can't understand why we haven't had a property bust.
The rich world spent most of the 1970s, '80s and '90s worrying about how to get inflation down to acceptable levels. We now know that, particularly since the advent of independent central banks and inflation targeting, the central bankers have got (goods-and-services price) inflation licked.
One small problem: as the global financial crisis so powerfully reminded us, in the process they've aggravated the problem of asset-price inflation, with its huge bubbles and terrible busts.
To date, the world's monetary economists are at a loss on how they can control goods-price inflation and asset-price inflation at the same time.
Twitter: @1RossGittins
Frequently Asked Questions about this Article…
Why has the Reserve Bank of Australia (RBA) been cutting interest rates recently?
The article says the RBA has cut rates because growth has slipped a bit below trend as mining investment is expected to peak earlier and lower than thought after falls in coal and iron ore prices. With inflation easing, the Bank has reduced the cash rate (about 125 basis points between November and June, and roughly a 150-basis-point fall since November) to try to restore non‑inflationary growth toward its medium‑term trend.
Will lower interest rates automatically bring the Australian dollar (Aussie) down?
Not necessarily. The article explains that although falling commodity prices and rate cuts could push the Aussie down, the historical correlation between terms of trade and the exchange rate can be loose for long periods. In practice the recent 150 basis‑point fall in interest rates has done little to reduce the currency, so a rate cut is not a guaranteed way to weaken the Aussie.
How do commodity prices and mining investment affect the Australian economy and currency?
High commodity export prices and a strong terms of trade have driven much of the Aussie’s strength during the resources boom. The article notes that a fall in coal and iron‑ore prices and some miners shelving expansion plans will cause mining investment to peak sooner and lower than expected, which pushes overall growth below trend and is a key reason for recent rate cuts.
What would the RBA do if the Aussie stays strong and growth remains below trend?
According to the article, the RBA would likely keep cutting the official cash rate until it saw growth returning to trend, because rising inflation pressure is the only thing likely to deter further easing — and with growth below trend that’s unlikely. The objective would be to stimulate interest‑sensitive parts of the domestic economy, like home building and commercial construction.
Could continued low mortgage rates spark another property boom, and why should investors care?
Yes. The article warns that returning to exceptionally low mortgage rates risks igniting another credit‑fuelled boom in property prices at a time when many households remain heavily indebted. For everyday investors, that means watching housing market and household‑debt risks, because a property boom and subsequent bust can have wide effects across the economy and financial markets.
Which theories explain movements in the Aussie dollar, and what does that mean for investors?
The article outlines three explanations: the terms‑of‑trade theory (commodity prices drive the currency), the interest‑rate differential theory (exchange rates reflect rate differentials with major economies), and a growth‑prospects view (countries with better growth prospects tend to have stronger currencies). For investors, this means the Aussie’s path can be driven by different forces at different times, so currency moves can be persistent and sometimes hard to predict.
How do inflation and asset‑price inflation factor into the RBA’s decisions?
The article says central banks have broadly brought goods‑and‑services inflation under control, but the global financial crisis highlighted that low interest rates can aggravate asset‑price inflation (bubbles in property and other assets). That tension makes it difficult for monetary policy to simultaneously manage both goods‑price and asset‑price inflation, and is a vulnerability in any prolonged low‑rate strategy.
What practical areas should everyday investors watch in light of the RBA’s 'plan B' to cut rates?
The article suggests investors should monitor the Aussie dollar, commodity prices, mining investment trends, and housing market signals. Interest‑sensitive sectors such as home building and non‑mining commercial construction may benefit from easier policy, but rising house prices and high household debt are risks to watch as part of broader portfolio and economic exposure.
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