By David Bassanese

Picking the month to month moves by the Reserve Bank of Australia so far this year has not been easy.  Financial market economists have really had to earn their money.

While I correctly anticipated last year the RBA would not be hiking interest rates anytime soon – and the bias on interest rates was still down – I’ve found the timing of the RBA’s actions (and non-actions!) this year a little hard to fathom. Thankfully, I was on the right side of the coin this month, correctly expecting the RBA would leave interest rates on hold – even though I still feel the RBA should be cutting interest rates without haste.  

Mixed messages

To be fair, the major difficulty the RBA has been faced with is quite divergent economic forces. On the one hand, house prices – particularly in Sydney – have been moving higher. Cutting interest rates risked adding fuel to the fire, as some media commentators have repeated ad nauseam.

Yet on the other hand, the price of our key commodity export – iron ore – has been heading south, and in turn undermining national income and probably national confidence to a degree. The slump in commodity prices has been far swifter and deeper than even the (at the time) pessimistic forecasts by the Treasury in late year’s May Budget and Mid-Year Budget Review.

Over the past month, there divergent trends intensified – Sydney housing auction clearance rates surged to record levels, while spot iron ore prices slumped below $US50/tonne, retracing much of the gains since the commodity price boom began more than a decade ago. 

Spot iron ore prices have slump by 40% from their levels around US$78 late last year.  My modelling suggests that implies the terms of trade could fall by around 10% in the March quarter and around a further 5% in the June quarter. And that assumes iron ore prices don’t fall further – which they well might.

Weaker commodity prices mean the slump in mining investment will be even deeper than currently expected. Weaker prices have also hit Budget revenues, making it even less likely that Canberra will help stimulate the economy by cutting taxes or boosting government spending.

The dollar daze

That leaves interest rates and the currency to help support the economy.  In an ideal world, the $A would be doing most of the work – as it would lessen the risk of low interest rates sparking a property price bubble. Yet while the $A has declined, it is has not fallen as swiftly as might be expected, given the slump in commodity prices – indeed, for much of the past year or so it has been uncomfortably overvalued. Near-zero interest rates and money printing programs in much of the developed world have not helped.

By global standards, official interest rates in Australia are still attractively high. That’s a magnet for desperate yield-seeking foreign investors, even in the face of commodity price weakness.

So the RBA – probably grudgingly – have been goaded into action.

Yet the RBA is also still counting on the $A to decline. While in previous months the RBA has argued that the $A remained “overvalued” given the decline in commodity prices, it’s statement this week ratcheted up the rhetoric a little further.  It now says “further [$A] depreciation seems likely”. 

Historically, it’s been very rare for central banks to openly comment on their national currencies, much less make predictions about where it is likely to go.  But such now is the desperation of the RBA in trying to get the $A down. The global currency war has changed the rules.

It begs the question: exactly how overvalued is the $A today?

By my estimates – using a model of the real (inflation adjusted) $A similar to that maintained by the RBA, fair-value for the upcoming June quarter seems closer to US68c than the current level of US77/76c. This factors in the anticipated drop in the terms of trade by around 15% over the first half of 2015 and a further official interest rate cut by the RBA to 2%.

 

In other words, the $A is today at least around 10% overvalued – which, while less than the 15% or so overvaluation evident in 2012 and earlier last year, is still uncomfortable.  

The RBA is hopeful that the $A will eventually react to fundamentals. The likely rise in US official interest rates from mid-year should also help pull down the currency.

But I suspect the $A won’t react as much as the RBA hopes unless it also lowers local interest rates further. Hence the RBA will be left with its dilemma.

At the end of the day, however, the bottom line is that the economy continues to grow at a below trend pace and the unemployment rate is rising. Sydney house prices may be hot, but that’s not enough to support the rest of the economy. And there’s a good chance deteriorating affordability will soon stem the rise in Sydney property in any case.

The RBA will likely cut interest rate again next month, especially if the March quarter consumer price inflation report continues to suggest inflation is benign. The RBA may well then pause for a time, but come later this year I suspect the RBA will again be forced to revise down its economic growth outlook and cut interest rate further.

My call remains that official interest rates will end this year at 1.5%, with the $A reaching (current fair-value) of US 68c.