Four key reasons why the dollar should remain weak

The response to US Federal Reserve Ben Bernanke’s comments about the possibility of ending its policy of quantitatitive easing has helped evoke a global sell-off as markets question his upbeat assessment of the US economy and express concern about a withdrawal of cheap money.

Weaker manufacturing figures from China have also helped send the Australian dollar below 92 US cents, its lowest level in nearly three years.

Professor Geoffrey Garrett, Dean of the Australian School of Business at the University of New South Wales, outlines four reasons why we might expect a lower Australian dollar in the future.

Reason 1: Money will get more more expensive in the US the better the economy does

Bernanke’s announcement indicates that the US is going to try to return over the next 12 months to more “normal” monetary policy. “Quantitative easing”, the Fed’s large bond buying program, has made money even cheaper than the near zero interest rates the Fed has set for several years. The fact that the market has reacted so negatively to an ending of QE tells you that there are lots of investors in the US who believe that the big run-up on the Dow Jones is a function of very cheap money, not improved fundamentals in the US economy. Any signal that the near free money’s going away will have a negative impact on Wall Street.

The headline unemployment rate in the US has been coming down, slowly but steadily, for a long time and will probably continue to do so. But I think the important thing to remember is that the standard unemployment rate is not as useful as it used to be because a lot of people are still counted as “employed” – that is, not showing up on the “unemployed” statistics – even if they’ve been moved from full-time work to part-time work involuntarily.

But even at 6.5% – which Bernanke has used as the trigger for a return to normal monetary policy – two things would be true. First, that’s a much higher equilibrium unemployment rate than the US has had in the past. The old figure used to be about 4.5%, so the US is going to be living with structurally higher unemployment now. Second, as I said, even at 6.5%, the number would conceal the fact that a lot of people want to be working full-time but only have part-time work.

What that tells us is that since the GFC American firms have figured out that they can make money employing fewer Americans than they used to. They’re outsourcing more to Asia and using technology more to reduce labour costs. So higher unemployment is going to be a big social challenge in the US, even when the conventional macroeconomic statistics look good.

So when Bernanke says “the economy’s doing well so we can think about returning to normal monetary policy”, the markets say, “Oh my god, free money’s going away. We’d better pull back”.

Reason 2: A slowing Australian economy means lower interest rates here

If and when US monetary policy returns to more normal, the interest rate differential between Australia and the US will go down.

In the past few years foreign investors have moved money into the Australian dollar because they can get a higher interest rate on lending than they can in the US. So if the interest rate differential goes down because money becomes a bit more expensive in the US, people who are lending money in the US will get higher rates of return, and money will flow out of the Australian dollar, lowering the exchange rate.

The less incentive people have to park their money in Australian dollars, the lower the dollar will go.

On the other side of the interest rate equation, the Australian economy is slowing down. That is why the Reserve Bank has lowered interest rates here. This also reduces the difference between US and Australian interest rates, again putting downward pressure on the Aussie dollar.

So there are two financial drivers pushing down the A-dollar: cheaper money in Australia and more expensive money in the US.

Story continues on page 2. Please click below.



Notify of
Inline Feedbacks
View all comments