Driving the Dollar Down With Interest Rate Cuts? Good in Theory

There is a groundswell of feeling among financial market participants, the business community and even some involved in policy-making that the Australian dollar is overvalued and that an interest rate cut from the RBA will help push it lower.

This sounds good in theory, but it ignores the simple fact that currency values – be it the Australian dollar, the yen, the euro or the pound  are driven by many more factors than interest rates. If interest rates were a major determinant of a currency’s value, the Indian rupee, for example, would be remarkably strong given that its interest rates have been broadly between six and nine percent for the last few years. This is well above the interest rates prevailing in the bulk of the rest of the world. Yet the Indian rupee has been chronically weak over that whole time. It is obvious that factors other than interest rates are driving the rupee’s value in perhaps a more extreme way than drivers of the Australian dollar and other currencies. Interestingly, in the whole period of general Australian dollar weakness in the past five years or so, when it fell from 1.10 to 0.70 against the US dollar, Australian interest rates have been higher than those in the US. Yet there has still been a massive depreciation. Issues relating to the terms of trade, commodity prices, risk, economic growth, changes in fiscal policy, the international trade balance and even debt have all been important in driving sentiment towards the Aussie dollar. The Australian dollar freefall was driven by a commodity price slump, a significant widening in the international trade deficit, greater risk assigned to Australia because of the housing market and banks all of which is compared to sharp improvements in the US economy. A slight closing in the differential in interest rates between Australia and the US also likely played a part, but the overall impact was slight. Which brings us back to the current debate concerning the wisdom on an interest rate cut to counter the recent lift in the Aussie dollar from a recent low of around 0.69 to levels now around 0.75 cents. Most basically, an interest rate cut would not work and would fly in the face of the fundamentally sound reasons why the Australian dollar has risen over the past three months. Most important in driving the dollar higher is the lift in commodity prices from the deep lows reached in January. At the same time, there is tentative evidence that the Chinese economy is finding a base – that is, it is reaching a turning point after the slowdown evident over the past couple of years. An upturn in Chinese economic activity and any further gains in commodity prices would justify a higher dollar and would offset any influence of an interest rate cut. What’s more, even if the RBA were to cut official interest rates to 1.75 per cent or even 1.5 per cent, the level of rates would still be well above those prevailing in Japan, the Eurozone, the US, Canada and the UK, meaning that capital inflows would still be attracted to the ‘high’ yields, even if some of the premium had been eroded. In other words, the dollar would still be well supported and would continue to be driven by factors in addition to interest rates. Perhaps most importantly of all, the overall economy does not need an interest rate cut from the current record low of 2.0 per cent. While growth is not particularly strong, it continues to expand at a pace that is keeping the unemployment rate at or slightly below 6 per cent. Even with the slight pick-up in the Australian dollar in recent months, it seems well founded and a sign of improving fundamentals. The RBA would be unwise to fight these trends in any way, but especially with an interest rate cut that is not needed and would not work. Stephen Koukoulas is the General Manager of Market Economics thekouk.com @Thekouk

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