$A overshadows ANZ rate rise

Alan Mitchell Economics editor

It’s not just the Dutch that we have to worry about catching things from.

Australia now has a slight case of Swiss Disease, and it could affect the way the Reserve Bank responds to events like ANZ Banking Group’s decision to up its lending rates.

Our dollar, at just over $US1.07 on Friday, is looking overvalued, especially since our non-rural commodity prices, which are a key driver of the exchange rate, have been falling since August.

And, as the RBA explains in its latest monetary policy statement, both the appreciation of the Australian dollar over the past couple of months and the decline in government long-term bond yields to close to 50-year lows have been driven in part by “significant purchases by non-residents, including sovereign asset managers”.

That is, central banks have been looking for a better place to invest their foreign reserves and, in the current global economy, Australia is looking more beautiful by the day.

Australian-dollar-denominated assets are “in”. The Australian long-term bond yield,  which was pushed under 3.8 per cent at the beginning of the month, was just a nose over 4 per cent on Friday.

But the Australian dollar is strongly affected by swings in the outlook for global commodity prices, which means not just the highly uncertain future of global demand but also the much-debated impact on commodity supplies of the global resources investment boom.

That presents a problem for the RBA as it tries to set its monetary policy “cash” rate against the medium-term outlook for inflation.

The medium-term inflation outlook is very largely the product of two forces: the once-in-a-century mining investment boom, which cannot help but generate inflation pressures in the wider economy, and the very strong but unpredictable exchange rate, which is now suppressing prices of internationally traded goods and services.

This could be seen in the December-quarter inflation numbers, in which the retail prices of internationally traded goods fell by 1.2 per cent in the quarter, while inflation in the sectors insulated from global competition was running above the RBA’s inflation target. As a result, the RBA wants to see a further reduction in inflation in the so-called non-traded sector of the economy.

If the dollar loses its newly acquired gloss, the economy’s underlying inflation pressures could suddenly emerge.

A change in sentiment towards the Australian dollar obviously could affect the way the RBA responds to increases in bank lending rates.

However, that should not mean that borrowers end up paying more on their loans than they would have had the banks slavishly followed the RBA’s lead.

It remains to be seen if all the other banks follow the ANZ’s lead. But, even if they do, it should not significantly add to the cost of servicing loans. That’s because the RBA sets its monetary policy so that the cost of borrowing (and, by extension, the strength of demand) is consistent with its 2 and 3 per cent inflation target.

If, because of the higher global cost of wholesale money, the banks increase their lending rates to a level that is inconsistent with the inflation target, the RBA can adjust monetary policy to reduce the cost of local short-term funds. Would the banks necessarily reduce their lending rates to take account of the lower short-term rates? Yes, competition between the banks is sufficient to produce the desired result, but the banks will also be under intense political pressure from the Gillard government. 

The result is that over the life of people’s loans, bank lending rates should not be materially higher as a result of their banks’ decisions to increase rates.

Of course that does not mean the RBA will automatically adjust its monetary policy as banks raise their rates.

The banks’ lending rates will just be fed, along with all the other economic data, into the RBA’s forecasts of the economy and inflation.

Nor does it mean that borrowing rates won’t go up as a result of, say, a decline in the value of the dollar and inflation pressures from the investment boom. But they won’t go up – and stay up – by more than the RBA wants them to.

The Australian Financial Review