The Australian dollar has climbed to fresh multi-month highs in early 2020 helped by a de-escalation in trade tensions between the United States and China and optimism that easier monetary policy settings will boost global economic growth in the year ahead.
However, despite the improved backdrop for the global economy, the stronger Aussie dollar risks creating an unwanted headache for policymakers at the Reserve Bank of Australia (RBA) in their attempts to grow the domestic economy sufficiently to lower unemployment, lift wage growth and bring underlying inflation back to within its 2-3 per cent annual target.
Demonstrating the importance the RBA is putting on a lower Australian dollar to achieve those goals, the bank said in its November Statement of Monetary Policy (SOMP) that a sustained 5 per cent increase in the value of the Australian dollar trade weighted index (TWI) is expected to lower Australian GDP by an average of 0.5 percentage points from its baseline forecasts.
Such a situation will create a scenario where little to no progress will be made in lowering unemployment and lifting wage and inflationary pressures over the next two years.
“This would keep the unemployment rate at around 5.25 per cent instead of declining to 5 per cent by the end of 2021 and keep trimmed mean inflation well below the bottom of the target band throughout the forecast period,” the RBA said in reference to the findings of its Macroeconomic Relationships for Targeting Inflation model, known as ‘MARTIN’ for short.
The RBA said the main drag on the economy from a stronger currency would be the impact on international trade, making Australian exports less competitive while simultaneously lowering the cost for imports.
“As a result, export volumes fall and imports increase,” the RBA said.
Without a strengthening in the currency, the RBA is forecasting that annual Australian economic growth will lift from 1.7 per cent at present to 2.8 per cent by the end of 2020 and 3.1 per cent by 2021.
Many economists believe the Australian economy needs to grow around 2.75 per cent per annum in order to keep unemployment and inflationary pressures steady. Should the currency continue to strengthen on a sustained basis, it risks keeping economic growth at levels insufficient for the RBA to achieve its unemployment and inflation objectives.
While the TWI finished 2019 at 60.3, not far off the 60.0 level forecast by the RBA, it has been trending upwards since early August, increasing by 3.1 per cent. Against the greenback, its gain has been even larger, lifting 5.2 per cent since early October, leaving it above 70 cents for the first time since late July.
According to modelling from currency strategists at the National Australia Bank, while the Australian dollar is not overvalued against the greenback at current levels, the RBA is unlikely to welcome any further strengthening in the currency given the downside risks posed to economic growth.
“For the RBA, one thing we learned in 2019 is its antipathy to a stronger Australian dollar,” said NAB head of FX strategy Ray Attrill.
Mr Attrill said the RBA’s decision to release analysis on the Aussie dollar’s impact on domestic economic growth suggests it now regards the level of the currency as an “explicit monetary policy objective”.
While Australian interest rate markets have scaled back pricing for an additional 25 basis point rate cut from the RBA by the end of next year to around 80 per cent, coinciding with benchmark Australian 10-year government bond yields lifting to a more than five-month high of just shy of 1.4 per cent, the NAB expects the RBA will continue to ease policy settings this year in an attempt to keep the Aussie dollar under pressure.
“We see the economy’s performance in the first half of the year justifying two more rate cuts…even with a somewhat more favourable global backdrop,” Mr Attrill said.
Eighteen of 22 economists polled by Bloomberg forecast the RBA will cut Australia’s cash rate to 0.5 per cent when it meets on February 4. In contrast, interest rate markets put the probability of a rate cut next month at just over 40 per cent.
Source: Thanks smh.com