Why RBA Wants Aussie Dollar Weaker

The Reserve Bank of Australia's (RBA) monetary policy statement has highlighted the downside risks to growth and inflation and reflected the central bank's concerns over 'high exchange rate', pushing the Aussie dollar, which had already fallen to a two-month low on weak labour market indicators, further lower.

The Australian central bank expects the non-mining economy to improve but the decline in the mining economy could weigh heavily on the overall growth, the Statement of Monetary Policy (SoMP), released on 8 August, showed.

"The decline in mining investment is expected to weigh more heavily than it has to date and the ramp-up in LNG exports is likely to build more significantly only towards the latter part of the forecast period," the August SoMP said.

The statement also talked about the downside pressure on wage growth owing to elevated unemployment rate and how can such pressures be offset by the pass-through of the weakness in the currency.

"Given the outlook for economic activity, the unemployment rate is expected to remain elevated for some time yet. The restraint that this implies for domestic costs should offset upward pressure on prices owing to the gradual pass-through of the depreciation of the exchange rate since early 2013," according to the statement.

The RBA said those forces have been roughly in balance over most of the forecast period, and therefore inflation is expected to remain consistent with the target, even with lower levels of the exchange rate.

At the policy decision on 5 August, the RBA had left the official cash rate unchanged at 2.5%.

According to the 7 August data, unemployment rate in Australia increased to a new multi-year high of 6.4% in July. It was a sharp uptick from June's 6% and compared to the market forecast of a repeat of that.

Australian unemployment rate has been steadily increasing since July 2011 when it was at a more than two-year low of 4.9%.

AUD/USD fell to 0.9239 on Friday, its lowest since 3 June, from the previous close of 0.9271. The pair had fallen 0.9% on Thursday weighed down by the unemployment data.

The Aussie dollar is down more than 2.7% from early July. From the record high of 1.108 touched two years ago, the regional dollar is more than 16% down.

That said, the fact the currency is still 6.7% stronger than the four-year low of 0.8660 touched in January is keeping the central bank concerned about the currency's strength.

"The exchange rate remains high by historical standards, with the Australian dollar little changed on both a trade- weighted basis and against the US dollar since the previous SoMP," the August statement said.

"The exchange rate is well above its level in late January, notwithstanding the decline in commodity prices and a narrowing in the interest rate differentials between Australia and most other advanced economies since then," the central bank said.

The rise in underlying inflation over the past year has in part owed to the earlier depreciation of the exchange rate, the RBA said, and added that a rise in import prices is being passed on gradually by domestic wholesalers and retailers, resulting in an increase in the prices of tradable items.

"Over the past year or so, pass- through appears to have been broadly in line with historical experience. Further pass-through of the exchange rate is expected to contribute around 1⁄4 to 1⁄2 percentage point to underlying inflation over each of the next two years," the central bank said.

"By late 2016, three and a half years on from the initial depreciation, these effects are likely to have largely run their course."

The RBA is also concerned about the exchange rate response to the commodity price movements and says that it is a source of uncertainty for the economy.

"Historically, a fall in commodity prices has, in time, led to a depreciation of the exchange rate. In the absence of such a response, a fall in commodity prices would lead to weaker GDP growth since softer incomes and government revenue would weigh on domestic demand."

"However, if the exchange rate were to move lower, this would provide some offset to the fall in commodity prices by helping to stimulate demand in trade-exposed sectors of the economy. A decline in the exchange rate would also add to prices over a period of time," the RBA said.

To sum up, the RBA means with subdued upside contribution to price pressures from the wage price side, the exchange rate has to be further lower for inflation to be around the target.