The Australian dollar is doing the job raising interest rates would do, says Michael Pascoe. Photo: Nic Walker
There's a problem for those predicting a Reserve Bank interest rate rise sooner rather than later: the stronger Australian dollar is already doing much of the job that a rate increase would do.
Much, maybe most, of the commentary about a possible tightening of monetary policy has concentrated on the Australian housing market. Yes, it's a very important part of the Australian economy this year and next, but it's certainly not the whole box and dice. The bigger question of when the RBA starts returning the present stimulatory level of interest rates to normal will depend more on signs of overall capacity restraints and signs that inflation might be on the rise – not just housing prices.
It's in that bigger picture that a strengthening currency mitigates against a rate rise. On more than one occasion, RBA officials have spelt out that they don't cut rates to try to weaken the surging Aussie dollar – they do it to ameliorate the impact of the strong dollar on the economy. It's an important difference, but apparently a very subtle one for some.
It follows that, all other things being equal, a weaker dollar stimulates economic growth, bringing the possibility of a rate rise closer, while a strong dollar mitigates against a rate rise when other pressures are pushing in that direction.
The general consensus has been that the Aussie would steadily weaken as the terms of trade came off and the US began its monetary "taper", winding down QE. That's certainly what the RBA has hoped and desired.
However, there is a growing suspicion that the RBA won't get what it wants. Former RBA board member and Brookings Institution senior fellow, Professor Warwick McKibbin, told the Institute of Chartered Accountants last week that his best guess is that we're experiencing a short period of $A volatility overlaying a long period of $A strength – five years or so of it.
McKibbin acknowledged the impact lower commodity prices should have, but said tapering only meant a lower Aussie relative to the greenback – our real effective exchanger rate with our major trading partners would be stronger. The shifts in global fiscal policies would cause capital to flow out of countries with large fiscal debt and to those with low fiscal debt – Australia.
On top of that, Australia has the prospect of higher productivity growth if key reforms are undertaken while global productivity is slowing – another reason for our dollar to strengthen. McKibbin also thinks our interest rates should be higher already, which would further add to our currency's attractiveness.
Market Economics' Stephen Koukoulas, the former economics adviser to Julia Gillard, has been successfully predicting a stronger Aussie for some months. He points to stronger global growth, strong Australian economic growth, interest rates rising here much sooner than later and commodity prices remaining relatively strong.
And then there's the reality of Australia being one of just a handful of nations with a AAA rating from all four major credit rating agencies. (Most people forget the fourth one, China's Dagong, which doesn't afford the US top status.) The world remains an uncertain place and Australia remains a stable, rich nation enjoying the rule of law, relatively little corruption, and a healthy fiscal balance, despite what the occasional Treasurer might want to tell you. As previously reported, scores of central banks now very happily want to hold our currency.
Of course, the Australian dollar partly exists just to prove forecasts of the Australian dollar wrong and the stronger-for-longer opinion is a minority one. McKibbin observes that, in the short term, it's what the market believes that matters most. It seems to me that the longer the Aussie stays up, the more the market may come to believe it will, with the caveat that China also stays strong – the most likely outlook despite what the China bears like to chant.
So, if the strong dollar is restraining economic growth, it becomes much harder for the RBA to lift rates if they only reason is the perception that housing prices are rising too far, too fast.
“Which in turn is why I suspect, contrary to many commentators, that the RBA has not given up on trying methods other than its blunt and brutal monetary policy to temper housing speculation – "macroprudential" policy that effectively discourages or limits housing investment. The RBA heavyweights have made it clear that they don't much like macroprudential because its most common form – tightening the loan-to-valuation ratio - particularly disadvantages first home buyers. Macroprudential is "not a silver bullet" and would only be "an adjunct" to their usual interest rate club, but they certainly haven't ruled it out, as was made clear in this exchange during last month's testimony before the House of Representatives economics committee:
Governor Glenn Stevens: " I said somewhere a few months ago that we had thought about this, we had had some preliminary discussions with APRA, which we had, and we promptly had a flood of FOIs for all the documents. That will all come out in due course. So we have thought about macroprudential tools. My view on them is they are a useful adjunct, but if we do use them we should go into this with a bit of realism.
"Let's be clear. For a start, if we were to have, say, a loan-to-value cap, who do you think will be most affected by that? It will be first-time buyers. I can imagine at the political level you will find that uncomfortable, should we proceed down that track. Indeed, I think the New Zealand experience is that, when the central bank announced that, the government felt obliged to do some offsetting things. So this is not necessarily straightforward.
"On the work that I have seen—and I can get Phil to speak here, because he knows more about it than me—the most effective tool could be that when banks test people for an interest rate, so you are supposed to be able to make the payments not just at the current rate but, say, 200 points higher, APRA could insist that the test be made 300 higher, or 400, or whatever, so that people do not get overcommitted. I should let Phil talk about it."
Deputy governor Philip Lowe : "I think the benefit of that type of approach is it allows lower interest rates to feed through into lower servicing costs for both new and existing borrowers, but it does not mean that lower interest rates keep on increasing the size of the loan that people can get access to, because the bank is applying a bigger buffer to the actual interest rate you pay. I think there is quite a lot of merit in exploring that. I know APRA is discussing that at various levels with the bank lenders.
"More generally, there is a lot of activity going on in different countries around the world in the macroprudential space and that is going to give us an opportunity to observe how those things work out. My tentative conclusion must be that it can work but it creates distortions, and in the end the distortions are quite costly and people work out how to get round the distortions. Macroprudential tools are very much like the tools we used in the 1970s and we ended up deciding we did not like those very much because you restrict one class of lenders, and the financial system is very flexible and another class of lenders comes up. The financial sector is very innovative.
"That does not mean these things are not worth exploring, but I do not think it is going to turn out to be a magic bullet, a silver bullet, particularly in countries like Australia where we have a flexible financial system, where there is a competitive fringe. In a more restricted system where you do not have markets and there is a lot more regulation you might be able to do this quite effectively, but our system is very flexible and we know that regulations create distortions and opportunities for people to take advantage of those distortions. So I think it is just a cautionary observation about how this can be used in practice here. "
Since then, the Reserve Bank of New Zealand has claimed success in using macroprudential policy to cool its overheating housing market by restricting the percentage of high LVR loans banks can make. Since October, the percentage of high LVR loans in kiwi banks' portfolios had fallen to 7.8 per cent – about half what the RBNZ had expected.
In one of those little coincidences that are sometimes interesting, an RBNZ paper on macroprudential policy options in March last year was prepared by Larmorna Rogers – an RBA officer then on secondment and now back in Martin Place.
However much the RBA might be wary of the Law of Unintended Consequences being at work when policy creates distortions, consider a scenario where the Australian dollar is stubbornly strong, making it harder for our economy to handle its transition from reliance on resources construction, when higher interest rates would further push up the Aussie, but when housing prices are continuing to rise, fuelled by low interest rates. In such a situation, would the RBA really want to land a double whack on the economy by lifting rates without at least trying a humble lead bullet?
Michael Pascoe is a BusinessDay contributing editor.