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February 9, 2015

The Surprise Rate Cut by Australia Central Bank

By Ari Charney, Investing Daily 
Although some economists believed recent inflation data would force the Reserve Bank of Australia (RBA) to hold steady on its benchmark cash rate, a majority of the smart money was betting on a rate cut. And the central bank delivered.
Last Tuesday, the RBA announced it had decided to lower its benchmark cash rate by a quarter point, to 2.25%. Prior to this week, the central bank’s rate-cutting cycle had been on pause since August 2013, when it lowered the cash rate to a then all-time low of 2.5%.
Thereafter, each statement that accompanied the bank’s decision on monetary policy included the soothing language that the “most prudent course is likely to be a period of stability in interest rates.”
And while some economists might have preferred the removal of that statement as an interim step toward an eventual rate cut, sometimes events overtake such niceties.
In this case, with so many of Australia’s central bank peers initiating further monetary easing in recent weeks, any delay in a rate cut beyond this meeting might have brought upward pressure on the country’s exchange rate.
Even with short-term rates at an all-time low, Australia’s debt still yields more than many of its developed-world peers, and if the RBA had failed to keep pace with other dovish central banks then that would have enticed capital inflows and undercut the aims of its policymaking.
The bank sees a lower exchange rate as crucial for the economy’s eventual rotation away from the resource sector, which is well past its peak in investment and suffering from sharp declines in global commodities prices.
RBA Governor Glenn Stevens has previously stated that he believes the fundamentals support an exchange rate near USD0.75.
And with the latest rate cut, that threshold is increasingly near. The Australian dollar currently trades around USD0.78, well down from the days when the resource boom pushed it as high as USD1.10 in mid-2011.
But Mr. Stevens is unrelenting. In his latest statement, he observed that even at current levels, the aussie “remains above most estimates of its fundamental value, particularly given the significant declines in key commodity prices.”
In fairness, he’s not merely looking at the currency’s erosion against the U.S. dollar, but also its performance against a basket of currencies, where it’s somewhat stronger.
In many ways, the country had become overly dependent on the resource sector, and a lower exchange rate will make the country’s exports more competitive in the global market, which should spur growth in some of the non-mining sectors. Given its proximity to fast-growing emerging Asia, Australia’s exports account for about 20% of its gross domestic product (GDP), compared to 13.5% for the U.S.
For now, the RBA says growth in domestic demand remains quite weak, while the flagging resource sector will keep the country’s economy operating at a below-trend pace “somewhat longer.”
In its semiannual Statement on Monetary Policy, the central bank reduced its forecast for full-year 2015 growth to a range of 1.75% to 2.75%, down from a prior range of 2% to 3%.
According to The Australian, J.P. Morgan chief economist Stephen Walters said the growth downgrade seemed to have been prompted by “cautious tales being told by corporates around their investment plans, gathered through the bank’s unpublished liaison process.”
Another factor in its outlook is that the bank expects unemployment to peak at 6.5% in 2016, a 15-year high. That’s a little later than it had previously expected, though the country’s unemployment rate is already at 6.1%.
Although the bank often includes some form of guidance with its monetary policy announcements, it was uncharacteristically silent on the future direction of interest rates. Economists with Westpac note that this gives the RBA “full flexibility to determine its next policy move without making any commitment to the market.”
Nevertheless, the market is fully capable of coming to conclusions on its own. And on that score, traders appear to be pricing in at least two more rate cuts. Based on futures data aggregated by Bloomberg, a plurality of traders expect to see the short-term cash rate at 1.75% or lower by August.
Courtesy Investing Daily (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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