AUD / economics / RBA

Commodities, job Vacancies and the AUD

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I have been fairly strident about the need for lower rates — ignoring some of the commentators that are generally well informed with regard to what the RBA is thinking. This may appear to be pig-headed hubris, as I’ve not fully explained my thinking — this post is an attempt to flesh out the dynamics that I see as the primary story influencing the Australian Economy just now.

First of all, we have the well known end of the commodity price boom. Some claimed that it never really lifted the economy — but I think that’s untrue. The reason i think it’s untrue is that the cycles in job advertising look closely related. Clearly, there’s a lot more going on in this sample, and anyhow we have two trending series — however for the period under under consideration (2006+) the relationship is also there in differences.

So when USD commodity prices are rising, so are job ads — and when commodity export prices are are falling, so are job ads. Clearly, there’s more to this story — in particular, it’s probably the AUD price of commodities that matters most.

You can see in the below chart, that there appears to be some relationship between Commodity Export Prices, the AUDUSD, and job vacancies. This is the relationship we are interested in — as it’s the one that’s changed in a way that’s a major negative for the employment outlook.

There are two ways of potentially capturing this: simply using the AUD price, or using the residuals from a regression of the AUDUSD exchange rate on commodity export prices. I’m going to use the second method, as it provides an immediate measure of the over- or under-valuation of the AUDUSD exchange rate.

The above chart shows the AUDUSD exchange rate, and the value predicted by the USD price of AUD commodities (alone). The missing variables are Australia’s desire for foreign imports and financial claims on the rest of the world, and rest of the world’s desire for AUD financial assets and the quantity of Australian Exports. Thus, this analysis assumes that all these other thing balance out.

This gives a neat and clear interpretation of the residuals — the degree to which these things have not balanced out. I think there are two major changes that explain why the AUDUSD is higher than export prices suggest it should be: 1/ a large increase in foreign demand for financial claims on Australia; 2/ a modest increase in export volumes. A partially offsetting change is an increase in Australia’s demand for foreign goods — due to internet shopping.

The conclusion of this analysis is that the AUDUSD exchange rate is about 10% stronger than is consistent with the historical relationship with commodity export prices.

This last step, is, unfortunately, a little harder to show without a sophisticated modelling framework. Anyhow, note in the above chart that AUD FX fell prior to the export price crash, and bottomed out before either export prices or vacancies. This is why monetary conditions indices are difficult to get right. Anyhow, the problem at hand is that if we simply regress one on the other ‘rich’ FX predicts increasing job ads, and ‘cheap’ FX predicts falling job ads.

So we need something more subtle. This takes the problem outside a simple blog analysis. However, put your thinking caps on and walk with me this last mile. If you accept that ‘cheap’ FX is stimulatory (it raises the return on capital in the trade exposed sector), then you must agree that a ‘cheap’ AUD boosted firms, and therefore prevented more widespread closure — and hence labor shedding. This shows up in our analysis as a reduced decline in job advertising.

It is this relationship that has changed this cycle — the AUD is not going down in anticipation of export price weakness. Export prices are falling, and the AUD is steady. As a result, firms are shedding labor, and job advertisement is declining (the level is now below the GFC low).

Clearly a fuller model is required, but my claim is that without the ‘weak’ AUD (relative to export prices) the economic decline would have been larger, and hence the decline in job advertising and hence the rise in the unemployment rate.

In conclusion, the reason that i think the RBA ought to cut their policy rate is that the level of the AUD is becoming ever more inappropriate as the level of export prices declines. Easing monetary policy sooner will prevent an unnecessary and undesirable increase in the unemployment rate.

16 comments

  1. Another cogently article. well done.

    I would have thought the reason for the $A not falling as usual with commodity prices was demand for our bonds.

    Another reason why Wayne Swan is both the worst politician to be treasurer but the best treasurer we have had!!

    1. agreed, bond demand seems the particular cause just now — i just left it as ‘demand for financial claims’ to keep it general.

  2. As I said in other comments, I do think you are over-estimating the impact that local rate cuts have / will have on the AUD…. if we get one or two more rate cuts and the economy does stabilize (unemployment / house prices) , the AUD will stay high. The AUD will come down only if local economic conditions weaken significantly. So if the RBA is successful short term, we will then pay the price of a structurally high AUD longer term. And I personally think it will be a higher price, because we can’t only live on mining and building unaffordable houses for much longer.

  3. ssec, are you suggesting that the RBA should not cut, in order to allow the economy to weaken, in order to bring down the AUD because that will lead to more balanced growth in the long term than simply lowering the cash rate now? I think that is asking the RBA to be too cute – not only highly risky (although you don’t seem that concerned about recessions) but effectively an attempt by the monetary authority to pick (sectoral) winners, which they have no mandate to do. As I understand Ricardo, he is saying that the overvalued dollar is a factor behind the current tightness of monetary conditions, and hence a reason for cutting rates. He is not saying that the RBA should cut rates to bring down the dollar per se. The RBA has one main policy tool and has to take other circumstances as given in pursuing its objective.

    1. It’s the high dollar that is having an impact on our economy, not the level of rates which are actually already accommodating. RBA should not cut rates to compensate for the high dollar. That would be a mistake for which we would pay later on. If the high dollar is the problem for our economy (and I think it is), let markets work that out, do not cut rates to compensate.

      1. … by cutting rates preventively, they keep “validating” the high dollar. Except, the economy needs a lower dollar, not lower rates. Let the market work that out.

        1. i don’t agree that they are cutting preemptively. I think that the economy looks weak — the best leading indicator of inflation is the labour market, and job ads are accelerating down (see today’s ANZ data for another example) which suggests to me that labour demand is tanking. The classic response is to ease monetary conditions to try and stabilise demand, and therefore prevent the increase in the unemployment rate / decrease in inflation.

          while i agree that none of this would be necessary if the AUD was 60c, i don’t agree that yields are irrelevant to FX determination. Since late 2011, the RBA has largely validated market pricing — so if the market is forward looking we should have only expected a modest weakening of the AUD. that’s what we have seen.

          What’s up for debate now is if they should disappoint — i bet you that makes the AUD stronger!

      2. Trimmed / median inflation at 2.5% is not “weak”, would be considered too high in most countries. You yourself say “which suggests to me that labour demand is tanking”. You are not sure. Everyone expected unemployment to increase, it hasn’t so far (not significantly). Interest rates are historically low already. Dwelling prices are stable after significant increases, it’s normal, would be worrying otherwise. Domestic inflation is at 4% already and it’s only cheaper imports that are keeping the averages down. The only reason the economy may look vulnerable is the high dollar. But the dollar is high because is being mispriced by markets, as you showed on your charts… so let the markets correct (they will if the economy is really suffering because of it, markets are very efficient).

        Regarding disappointing and making the AUD stronger: that would only last until the next unemployment report or the next disappointing economic release. The last rate cut resulted in a decline of about 150 bps in the week after, however but by the next (positve, there were jobs created) unemployment number, it was all gained back. The differential between AUD and EURO / US dollar rates is so large that AUD rates are quite insignificant in the equation at this stage. What counts is China and real data.

        1. that’s a coherent alternative view — and a reason they may pause. our differences come down to two things — what one makes of the policy changes and their contribution to Q3 CPI (i think ex-policy it was ~0.5%q/q) and how you feel about jobs v. unemployment rate in the labour market report (i favour using only the ratios).

          any coherent model has a +ve association between the yield gap and the currency — so long as credit is stable — i think we are only arguing about magnitude. it’ll help some.

  4. Just in case you thought otherwise I wasn’t criticising you.

    I will wait until the next Cochrane episode for that!!

  5. it would be nice to see a post from you explaining how you got November so badly wrong after numerous posts here arguing the case. i noticed you wrote at great length about how you got October right. learning from one’s mistakes is important.

    2. Ricardo’s analysis and interest rate calls are still the most professional and scientific out there, are supported by facts and numbers and are 100% unbiased (**most important!**). Most of other commentators are guided by self interest, political interest or economic interest (must say that myself tend to do that error sometimes, confuse what is good for me with what is GOOD in general). You have the chronic bulls and the chronic bears, cherry peaking statistics all the times and numbers to fit their views (you still should read those, so you always remember what error you should not do). You have the famous economic journalists that like to express their “feelings” and are just as reliable as Black Jack. Yesterday decision was 50/50, that was clear. The minutes confirm that. Data and scenarios were clearly on the table; I reckon the last inflation number plus the fact that we had already 150 bps of cuts prevailed and the board decided for a pause. However tomorrow job numbers could already vindicate Ricardo. Will see.

      1. thanks mate. though i must congratulate you on your good judgement yesterday! well played on the hold at 3.25% call.

        as for jobs, we will see tomorrow — but even if the unemployment rate is steady, i think the medium term story remains the same for the RBA: how to boost broad investment when the AUD is depressing the return on capital in sectors that (partly due to the high AUD) already have excess capacity. As the boom matures, this will be the key task for policy. it would be a lot better if the government did some infrastructure investment, but that seems politically impossible.

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