Stevens' reasons not to kick the dollar down

Having got what it wished for will the Reserve Bank now sit on its hands for a while and preserve its remaining monetary policy firepower?

We may get some kind of answer to that when the Reserve Bank board meets next week and Glenn Stevens releases his usual statement outlining the influences on the board’s decision but clearly the RBA, increasingly concerned about the stubborn strength of the Australian dollar, would be well-pleased by what has transpired since its decision to cut rates by 25 basis point at its May meeting.

Since that decision there has been a very sharp fall in the dollar and not just against the US dollar, where there has been a depreciation approaching 6 per cent. It has fallen about 5 per cent against our major trading partners.

The Reserve’s decision, which narrowed the rate differential against those economies pursuing quantitative easing policies and therefore may have played a role in reversing capital flows, coincided with intense speculation that the US Federal Reserve board was contemplating a tapering of its QEIII program.

That speculation, which abated somewhat overnight on the back of some weak economic numbers in the US, has probably been more of a factor in the depreciation of the Australian dollar than the RBA’s actions.

The US dollar has strengthened appreciably against most of the major currencies, with the speculation about the Fed’s intentions having a marked impact on markets and producing considerable volatility as yield-chasing investors abruptly started considering risk.

Over time the fall in the Australian dollar, if sustained, ought to provide some relief for the non-resource and trade-exposed sectors of the economy, although by historical standards it remains high. It is the equivalent of a rate cut by itself and therefore may be enough for the Reserve Bank to stay its hand.

The RBA would, however, be mindful that its succession of rate cuts over the past 18 months, which have pushed official interest rates to record lows, haven’t had much impact.

Consumer and business confidence and activity levels remain low, the peak in the resources investment boom was reached last year and apart from those projects already under development the pipeline of future projects essentially falls away abruptly from next year.

There are no signs of any real resurgence of confidence or investment in the non-resource sectors, the announced closure of Ford’s local manufacturing facilities highlighted the steady increase in job-shedding across the economy – there is a massive wave of cost-cutting and job losses now under way in the resources sector -- and the public sector is contracting and could be expected to contract further if the Coalition wins the federal election in September.

Economists are dividend in their view about the condition of the economy and on the likelihood of further rate cuts, with some convinced that as the resources boom recedes and the dollar retreats it will be possible to finesse a relatively smooth re-balancing of economic activity towards the non-resource sectors.

With both major parties committed to deficit reductions the RBA and monetary policy will have to play a pivotal role in any finessing.

With the fate of the dollar apparently tied to developments in the US and the actions of the Fed the RBA might want to hold off, preserve its firepower and options and wait to see whether more positive signals from the US economy will trigger another downward lurch in the value of the Australian dollar without its own intervention.

Alternatively, it could decide to give the markets a bit of a shove and cut again to narrow the appeal of Australian yield even further and perhaps give the unwinding of the various carry trades that have helped prop up its value another kick along to force it down to levels Australian exporters and trade-exposed industries can live with.

Given the extent of the movement in the dollar since the RBA’s last meeting it probably will feel under little pressure to act with any urgency until it has more time to determine whether the combination of its own rate-cutting since November 2011 and the belated fall in the dollar are sufficient to generate some non-resource confidence and activity.

It did, however, surprise last month and it would be no surprise if there were further rate cuts this year, whether or not there is any further movement next week.