Cash rate on hold, but a war of words on the exchange rate

The RBA kept the cash rate on hold today. This was expected, despite the latest inflation rate figures being slightly higher than expected.

The RBA have tended to over react to inflation figures in the last eighteen months, which is odd because they know interest rates take up to two years to affect the headline inflation rate. On this occasion other considerations may have outweighed inflation concerns.

The RBA are worried about the future growth of the economy. The mining sector is investing less and the fall in commodity prices means that export values are falling. Together that means lower Aggregate Demand and so lower inflationary pressure in the medium term.

The non-mining sector has to provide the growth which is necessary to maintain employment. A key issue for the non-mining economy is the exchange rate. The resources boom pushed the exchange rate up, made imports cheaper and exports more expensive for foreigners.

Now the exchange rate needs to fall to help the non-mining sector grow. Imports will be less competitive and exports cheaper allowing a boost to Aggregate Demand (assuming the Marshall-Lerner conditions hold).

The RBA could lower interest rates to help make the $Aus less attractive to hold (as relative exchange rates abroad stay the same). Instead they have opted to 'talk down' the $Aus in order to achieve the lower exchange rate. They clearly indicate that a lower interest rate will be set next year, which should lead to a fall in the exchange rate. But now the $Aus should fall on the expectation of this change. Why hold Australian dollars until they fall in value when you can sell now?

So the RBA can eat their cake and have it. They maintain anti-inflationary pressure by not lowering interest rates and get a a lower exchange rate to help boost growth. Let's hope it works.

The Australian makes the position clear here