Australian dollar poses problem for RBA

"The Australian economy is evolving broadly as expected. The Bank's forecasts are little changed from those published in the May Statement on Monetary Policy. The economy is expected to grow at an annual rate of around 3% over the next couple of years, which is a bit higher than estimates of potential growth. The unemployment rate is accordingly expected to edge lower. Underlying inflation is higher than late last year; it is expected to reach around 2% over the second half of 2017 and increase a little thereafter. The forecast for headline inflation has been revised a little higher, and lies between two and 3% over much of the forecast period."

This was the Reserve Bank of Australia's (RBA) opening paragraph in its 'Statement of Monetary Policy' report for August 2017. The overall tone of the report was bullish and one that's already painted by RBA governor Philip Lowe's statement after the bank's board meeting on 1 August (where it kept the official cash rate unchanged at 1.5%).

But despite the RBA's optimistic outlook, the domestic equity market appears to be going nowhere. This year to date, the All Ordinaries index is up 0.9%. Never mind comparing it to the S&P 500 index - up 10.6% for the year - but the All Ords has not even produced even half of the FTSE100's 5.2% gain (despite lingering Brexit uncertainty); nor the Nikkei225's 4.4% appreciation (despite its continuing battle with very low inflation); nor the Shanghai composite index's 5.1% increase (despite the PBOC's liquidity tightening and de-leveraging actions).

For the explanation, we don't have to look further than in one of the "key uncertainties" the RBA nominated in its 'Statement on Monetary Policy'. To wit:

"The exchange rate is another source of uncertainty for the forecasts. The Australian dollar has appreciated by 5% on a trade-weighted basis since the May Statement, and by 7% against the US dollar. This has been incorporated into the current forecasts. It is possible that the Australian dollar could appreciate further, which if sustained, would be expected to result in a slower pick-up in economic activity and inflation than currently forecast," it said.

"Based on historical relationships, a 10% appreciation of the trade-weighted exchange rate (that is not associated with higher commodity prices) would be expected to lower year-ended inflation by a little less than 1/2 percentage point over each of the following two years or so. Output would be expect (sic) to be lower by half to 1% in around two years' time."

This year to date, the Australian dolla3r has risen by 9.3% versus the greenback and 5% on the TWI. In comparison, the British pound has risen not as much (up 5.5 %) against the US dollar while the Japanese yen and the Chinese yuan have appreciated by 5.2% and 3.4%, respectively.

Although it still has scope to lower borrowing costs (if necessary), the RBA's problem is it cannot even promise to lower interest rates to bring down the Australian dollar without re-energising the property market and lifting Australian household's ballooning household debt.

Read more: USStatement on Monetary PolicyAll OrdinariesBrexitPBOCPhilip LoweReserve Bank of AustraliaS&P 500Shanghai
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