This article explores how changes in the cash rate impact the exchange rate, and what this means for our economic fundamentals.
The outbreak of the COVID-19 is primarily a public health crisis, but has had tremendous impacts both economically and financially, much of which has been felt within Australia.
Australia’s GDP growth is at 2.2%, the unemployment rate just edged up to 5.2% in March 2020, and inflation rate stands at 1.8%.
These figures remain out of their respective target bands, below the medium term trend in the past 5 years and are being exacerbated by the pandemic, reflecting our major economic slowdown. At some point, the virus will be contained and the Australian economy will recover. In the interim however, it is of utmost importance for the Reserve Bank to support jobs, incomes, and businesses through the use of monetary policy.
The RBA has been consistently decreasing the cash rate for the past 33 months, and in February 2019 it stood at 0.75%. However, the unparalleled health crisis prompted the board to reduce the cash rate twice in March 2020, to 0.25%. This is boosting the cash flow of businesses, and the household sector as a whole, but at the same time has indirectly affected our exchange rate. This has been witnessed in the declining trend of the Exchange Rate. The Australian dollar was worth $0.70USD at the start of 2020, a figure which has fallen to an 18-year low of $0.57USD.
The downward pressure on the Australian dollar has also been reflected in the Trade Weighted Index which has fallen from an index of 58.1 in January of 2020 to 54.7 in March of 2020. While the impact the interest rate has on the exchange rate is largely unintentional, the Reserve Bank Australia kept in mind that a depreciation of the currency would stabilise Australia’s trade exposed industries. Theoretically, a depreciation makes our exports cheaper for foreign countries, hence raising the international competitiveness of our exporting industries, which in this current circumstance is a priority.
Monetary Policy involves action by the reserve bank, on behalf of the government, to influence the cost and availability of money and credit in the economy. It’s a macroeconomic policy that may be used to smooth the effects of fluctuations in the business cycle and influence the level of GDP growth, inflation and unemployment. The reserve bank manipulates cash rates through domestic market operations. Currently, the RBA is purchasing second hand commonwealth government securities from banks, and in return depositing cash into bank’s exchange settlement accounts. This increases liquidity and thereby places downward pressure on the cash rate. The cash rate is the interest rate at which banks borrow and lend between each other in the Overnight Money Market. Due to competition between banks the lower cash rate would be passed on in the form of lower commercial interest rates (corporate and personal loans).
There are multiple ways in which the RBA can influence the value of the Australian dollar.
Direct intervention, also known as “dirtying the float” involves participating in the FOREX market as a direct buyer and seller of AUD in exchange for foreign currencies; during the GFC the AUD depreciated from $0.94USD to $0.66USD, and in order to curb this rapid depreciation the RBA purchased $33bn of AUD. Jawboning, is the use of public sentiments in order to influence investor perceptions about changes in supply and demand of the Australian Dollar; the RBA in 2017 “expressed concern about the strength of the AUD” which resulted in speculators being reluctant to invest in AUD, ultimately leading to a depreciation.
However, the method the RBA is currently using in light of the COVID-19 pandemic is indirect intervention, which entails manipulating the value of the AUD through monetary policy. The decreased cash rate is less attractive for foreign investment and savings due to lower returns, declining the demand for AUD. People would be more inclined to direct their financial flows towards countries with higher interest rates, and in order to do this would sell off Australian currency and purchase other currencies. This would increase the supply of the Australian Dollar. The increased supply and demand of our currency would ultimately depreciate our currency.
It is important to recognise however, that influencing the exchange rate is not a primary objective of the RBA. They are much more concerned with our economic growth, price stability, the maintenance of full employment, and the overall economic prosperity and welfare of the people of Australia.
The depreciation helps improve the international competitiveness of our trading sector, making our exports substantially cheaper for foreign countries, which is essential in light of the significant trade restrictions that have been imposed to minimise the spread of the coronavirus. Stabilising our export revenue is important as this is a component of Aggregate Demand, the driving force behind our economic growth.
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