Catch-22: The RBA's Policy Dilemma and Implications for the Australian Dollar

Executive Summary

The Reserve Bank of Australia (RBA) has found itself in something of a bind recently. After a series of gradual rate cuts over the past several years aimed at cushioning the Australian economy’s adjustment to slower growth and lower inflation, debt imbalances among Australian households have steadily grown as low interest rates have fueled a sharp rise in house prices. Burdened by this growing pile of liabilities, consumers are also facing rising unemployment and a still-weak economy and thus could benefit from lower rates; however, additional rate cuts risk even more piling-on of debt. In this special report, we review how the Australian economy and the RBA got to this point and what the RBA’s likely next course of action could be in addressing its conflicting concerns. In all, while we do not necessarily expect further rate cuts from the RBA at this time, we also do not believe Australian economic fundamentals currently justify an increase in interest rates any time soon. With the RBA likely to be on hold until well into 2018 and the Fed expected to continue raising rates, we see downside risk for the value of the Australian dollar against the greenback.

RBA’s Paradox: Stave Off Debt Risks While Supporting Soft Economy

The Australian economy fared better than most advanced economies during the global slowdown of 2009 due mostly to Australia’s trade ties to China’s economy, to which it sends around a third of its exports. Real GDP in China continued to grow at a respectable pace in 2009 and 2010 even as growth in much of the rest of the world struggled. Since 2011, however, the moderation in China’s GDP growth, particularly in the past couple of years, has translated into a generally weaker profile for export growth in Australia. In turn, this has had negative knock-on effects for its mining sector and raw material exporters, which has fed into weakness in overall Australian economic growth more broadly.

To be sure, Australia’s economy remains bifurcated, with the resource-dependent states still trying to recover even as the rest of the country is faring pretty well. Final domestic demand, or the sum of total final consumption and investment, in the resource-rich states of Queensland and Western Australia is roughly 8 percent below its peak in Q4 2013, while final domestic demand in the rest of the country has grown 10 percent since then. In aggregate, however, Australian final private demand is soft, while public spending is pulling a good bit of the weight at present. Since 2015, for example, government spending growth has averaged 5.1 percent, while the average growth rate for consumer spending was only 2.8 percent and business fixed investment growth was negative for that same period. Thus, despite the somewhat divergent fates of resource and non-resource rich states in Australia, aggregate growth figures clearly point to an economy in which overall demand is subdued. 

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