23/05/2013 - 14:34

Australian economy not so special

23/05/2013 - 14:34

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The relationship between the high $A and interest rates has a way to run.

Australian economy not so special

The relationship between the high $A and interest rates has a way to run.

THERE has been a tendency for Australian economists and policymakers to view Australia as ‘different’ to other developed economies. After all, Australia suffered neither a banking nor a housing collapse during the GFC.

Indeed Australia even escaped a severe slowdown while much of the rest of the world found itself in recession.

Coming out of the GFC, the Reserve Bank of Australia increased interest rates seven times, with consensus expectations by mid-2010 being that the cash rate would peak around 5.50 per cent. The $A was expected to head back to the mid-80s on a two-year horizon, and the budget was forecast to come back into surplus in 2012-13.

In short, Australia had escaped the GFC.

We view things another way. Indeed we increasingly see Australia as little different to other well managed, commodity exporting, developed economies.

Admittedly with the benefit of some hindsight, what appeared to make Australia different over the second half of 2008 through to 2012 were largely temporary factors.

A well-timed and very large fiscal stimulus underpinned growth during the depths of the global recession. That was then followed by a surge in Chinese steel, iron ore and coking coal prices. This surge in bulk commodity prices lifted the terms of trade by a third over an 18-month period. It also underpinned very strong nominal GDP growth and a buoyant labour market.

The increases in commodity prices then flowed into a mining investment boom.

But the fiscal stimulus is no longer. The surge in the terms of trade gave way to a significant decline through 2012, and the mining investment boom is peaking – with investment across the economy as a whole having peaked last year.

Put simply, the factors that made Australia ‘different’ are no longer in play. Indeed a progressive easing in monetary policy has accompanied the dropping out of these drivers of (past) economic outperformance. At 2.75 per cent the cash rate is closing in on policy rates in New Zealand (2.50 per cent), Canada (1 per cent) and

Norway (1.50 per cent).

Of course, the exchange rate has been high over the entire post-GFC period and has (indirectly) been in large part behind the easing in monetary policy.

But an elevated currency is not unique to Australia.

Canada, New Zealand and Norway also have currencies well above long-term averages, and policy rates well below long-run averages.

In our view, the causality has been running from currencies to interest rates. That is, it is the strength in the $A that has (in part) been behind the 200 basis points of rate cuts locally during the past 18 months.

Looking forward, fiscal tightening could well crowd out monetary tightening over 2014 and 2015. This infers, of course, a longer period of lower rates.

In fact, should the exchange rate remain elevated, we can see the cash rate at low levels for some years.

The glue that holds this framework together is the $A, and specifically having the causality run from currencies to rates and not the other way around.

Ultimately it will be a much stronger $US and weaker local currencies that enable central banks to lift rates across the ‘dollarbloc’.

Until that happens, the prospect of more fiscal tightening and a still high $A suggest rates will remain low for long.

• This article is an extract from the Deutsche Bank Markets Research publication ‘Australian Monthly’, of May 15 2013.

Adam Boyton is chief economist at Deutsche Bank Markets Research Australia
Phil Odonaghoe is an economist at Deutsche Bank Markets Research Australia

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