Despite the RBA’s efforts to kill the beast in the June RBA meeting minutes (see this post), the “lower AUD means the RBA should not cut” beast is stirring.
This time it’s in my mate Chris Joye’s weekend AFR column (I always like reading Chris, but we’ve been at odds on inflation for the last five years).
Here’s an extract from Chris’s note:
My final message is to expect a new debate to emerge about how the RBA should respond to a revival in inflation. We are already seeing the first pre-emptive demands for the RBA to “look through” imported or “tradeables” inflation fuelled by a falling exchange rate.
These arguments will doubtless come from the same folk who clamoured for the RBA to ease policy on the back of the tradeables deflation our ascending exchange rate delivered. You’ve got to love the inconsistencies: an appreciating dollar means rate cuts, but we don’t need increases on the way down.
Chris has been warning about this ‘risk’ for some time. That warning has been falling on deaf ears for about the same amount of time. It’s been falling on deaf ears for good reasons: we ought always to ignore shifts in relative prices that are due to appropriate macro adjustments.
The question of if we ought to care about the first round effects of a level adjustment in the AUD really boils down to a view about the labour market. If workers are able to negotiate an increase in their nominal wages to compensate for the decrease in their real wage (due to the higher price of imported consumption goods) then the RBA ought to worry about the falling AUD. This would be the case if the labour market was tight.
If, on the other hand, the labour market is slack, workers are likely to simply accept the real wage cut. This seems likely to be the present case: and if i’m right about that, if follows that the central bank should not worry about the import price shock.
In a note on the falling AUD, the Age’s Peter Martin quotes Treasury Secretary Parkinson and his Deputy David Gruen, saying basically the same thing:
As the Australian dollar slid below 95 US cents for the first time in 30 months on Thursday Dr Parkinson told a Senate hearing the Bank should “look through” the inflation consequences of the sliding dollar and continue to keep interest rates low or cut them further even as the falling dollar pushed up prices.
“I wouldn’t wish to speak on the governor’s behalf and as a board member it is always a slightly difficult situation,” he said.
“But they could basically keep interest rates at a particular point, or they could lower them further, and just accept that inflation went out of the band for a period. Then, you know, they could try and stop the second round effects.”
He was backed up by his deputy David Gruen who said the Reserve Bank’s “flexible” target meant it could allow inflation to climb above the top of the 2 to 3 per cent target band so long as it did not spark a wage-price spiral. Inflation is at present 2.5 per cent. A sudden increase in rates in order to contain inflation as the dollar fell could harm the economy and prevent the dollar from falling further. It has slid from 102 US cents to 94.6 US cents in the past five weeks.
We ran this debate in the 1990s, when the TWI dropped 15% following the Asian Financial Crisis. Despite all sort of howls from the MCI crew about how the lower AUD was boosting demand, the RBA cut their policy rate by 125bps between 1997 and 1999. The RBNZ raised rates, and subsequently dumped the MCI as an operational target.
In my view, the present adjustment is a similar shock: the AUD is (appropriately) weakening due to the terms of trade drop. The labour market is weak, so the probability of a core inflation problem is small: it follows that monetary policy should seek to encourage this adjustment.
Appreciate your work matey. Good stuff.
thanks for your support manny. catch you when i get back.
I pretty much agree, Ricardo, but I would express it slightly differently. A really useful Sumnerism is “never reason from a price change”. So the reason why the dollar falls is important. I can think of three main reasons why the AUD would fall: (1) If it falls due to slowing world growth or tighter policy elsewhere, then the falling dollar is merely a second-order reflection of that lower expected demand. In this case (as in the Asian crisis), the central bank should not stop loosening policy, but may need to loosen less than if the ER were fixed. (2) If it falls due to an exogenous reduction in investors’ willingness to hold AUD, then a falling dollar can be inflationary. You suggest that in this instance, the state of the labour market is key to whether the RBA should worry. I disagree with you a bit here. I would treat such an exogenous change in preferences as a one-off shock to both supply (negative) and demand (positive). Prices will rise, but the effect on output is ambiguous. Attempting to counteract the effect on prices by tightening policy could simply reduce output below the full employment level and make people worse off. This is where policy needs to simply ‘look through’ the initial impact. (3) If the dollar falls because of unanticipated expansionary monetary policy (as immediately after the May RBA cut), then the fall is just reflecting the loosening. Of course, in the real world, currency movements are often due to a combination of these factors.
Unless the central bank operationalises policy by pegging or targeting the exchange rate, I see no reason why they need to react to changes in the currency at all. Just like I don’t think the Fed or the BoJ needs to care about rising long term bond yields as they go about implementing policy. To draw attention to these second-order impacts just confuses the market and diminishes the clarity and effectiveness of the policy.
On reflection, I guess a depreciation purely due to an exogenous change in preferences will be expansionary. (I guess I was assuming that in most cases, reason (2) would be combined with reason (1), which makes it harder to work out whether the overall effect is expansionary.) Anyway, if the dollar fall is solely due to an exogenous change in preferences, I agree with you that the state of the labour market is important. Chris would be right if policy were not currently too tight.
the inflationary case is that AUD is falling solely because the US economy is very strong. In that case, our currency is weaker and there’s more demand, so the RBA ought to tighten.
Some are trying to make this case, or something like it. I think the AUD is weak because the miners have stopped buying it — as they are slowing the pace of their investment.
I think it started falling when the RBA cut unexpectedly in May (reason 3) and continued falling when the Fed, Abe and ECB indicated possible tightening relative to expectations (reason 1). Either way, I don’t think there’s any need for the RBA to let the fall get in the way of further rate cuts.
Thanks Ricardo, very good post…again. I’m amazed at how quickly the debate about monetary policy has switched back and forth over the last 12 months.
A low AUD will not cause inflation because the amount of money circulating in Australia is still the same. If tradable goes higher, non-tradable will go lower. What counts is the overall saving rate and credit growth, but if that don’t change, there’s no inflation coming. Even I – that I am no economist – I understand that basic fact.
The AUD is depreciating because rates are dropping in Australia and will keep dropping, and rates are dropping because Cinda is slowing, 10 years bond differential is getting smaller and smaller and everyone knows the triple-A rating is completely irrelevant.
…. and the S&P/ASX 200 is back at 2005 levels and house prices have been flattish since 2008 …. so where is inflation coming from?
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