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By HaleStewart October 23, 2013 8:12 am
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RBA Should Lower Rates to Stem Aussie's Rise

A recent Bloomberg article highlighted the general consensus that Australia will not be lowering rates anytime soon, largely because their previous rate cuts are already filtering through the economy leading to a better overall growth picture.  But here, I will make the argument the RBA should cut rates an additional 25 basis points for two reasons: growth is still below par and the Aussie has recently risen to a high enough level to slow exports and therefor overall growth.

First, let’s provide a bit of historical background for the Australia.  For the last 10 years, the economy has been one of the primary beneficiaries of the “south-south” trade, where raw material exporters sold record amounts of their respective exports to China, as their economy ramped up overall growth. 

As the chart above shows, total Australian exports increased strongly from 2004-2008.  While they understandably decreased during the Great Recession, they have since rebounded.  However, notice they have not surpassed pre-recession highs.  The primary reason for this is China is trying to rebalance its economy from one driven by investment and exports to one driven by internal demand.  As a result, their need for raw material imports has decreased, negatively impacting all of their primary suppliers, of which Australia is one. 

As a result, the Australian economy has been growing below their potential, which has been noted by the RBA in their recently released meeting minutes:

The national accounts data for the June quarter, which were released the day after the previous Board meeting, confirmed that the economy had been growing at a below-trend pace up to the middle of the year. Members were informed that recent indicators suggested that growth remained below trend into the September quarter. The transition from the investment phase to the production phase of the resources boom had become more evident over the course of the past year. The decline in business investment in the June quarter, especially in mining investment, was evident in falls in investment in machinery and equipment as well as in engineering activity. Export volumes had increased, driven by higher iron ore and rural exports, and strong growth in resources exports was expected to continue in coming quarters with more mining projects scheduled to come on line.

To counter the slowing economy, the RBA has been lowering rates:

For the last two years, the RBA has lowered short-term rates from 4.5%-2.5%.  However, this lowering of rates has not led to a decreased overall Aussie dollar as shown by this chart of the Aussie’s effective exchange rate from the Bank of International Settlements (BIS):

As this chart shows, it wasn’t under March of this year when the Aussie finally started dropping, and that was as much a function of the anticipated Fed tapering as it was the RBAs interest rate policy. 

However, despite the BIS’ chart demonstration of the overall drop in the Aussie’s value, it has recently increased verses both the dollar and yen.  The Aussie was trading a little above parity versus the dollar for the early part of 2013.  But it started to drop in March, eventually falling to a little under .90.  But over the last few months it has risen to .96.  Versus the yen, Aussie rose to a little above 100, but fell to 90 in the spring.  But price action since the beginning of September has the yen increasing again to a little over 96.

The combined total of the above data points indicates the RBA should strongly considering cutting rates at least another 25 basis points.  First, they clearly have room to do so; short term rates are at 2.5%, making them some of the highest in the developed world.  The inflation rate has been fluctuating between 2% and 2.5% for 2013, indicating inflation isn’t a problem. 

Second, a rate cut would obviously help to spur economic growth, hopefully increasing it to above the “subpar” reading.  And, third, the cut would help to lower the Aussie verses other currencies, thereby increasing Australian exports.

With inflation under control, an increasing currency and a slower than projected economy, the RBA should lower rates an additional 25 basis points.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer

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