16/02/2023

The plan by America’s central bank to allow inflation overshoot will put upward pressure on the Australian dollar, boost local shares and property but make the RBA’s job harder, economists said.

“It is also likely to make the USD weaker than it otherwise would.
“This may temper currency exposed companies in Australia but more likely it will allow the RBA here to leave rates lower for longer and maintain their yield curve control mechanisms thus reinforcing rising the local equity markets and Australian residential real estate.”
Yarra Capital Management head of macro and strategy, Tim Toohey, said the RBA would likely be “disappointed” by the Fed’s shift both because of the impact on the currency and the Fed rejecting the RBA’s yield curve control strategy in buying bonds to drive down long term rates.
“It’s a really clear line in the sand the Fed wants more risk-taking from business and people and that if they eventually do raise rates they are going to be very late taking away the punchbowl.
“That’s US dollar negative, Aussie dollar positive, and good for financial stocks.”
With the Fed funds rate anchored near zero and inflation weak, a key motivator behind the Fed’s change is to boost people’s inflation expectations, a major determinant of actual inflation.
Real v nominal exchange rate
Former RBA board member and Australian National University economist Warwick McKibbin said the Fed’s soft version of “price level targeting” would push down the US dollar and could undermine the greenback’s status as the world’s reserve currency.
Australia’s nominal exchange rate would be stronger but the real exchange rate which adjusts for inflation would be less affected because US prices would be relatively higher, said Professor McKibbin, who is also a nonresident senior fellow at the Brookings Institution at the Fed’s home in Washington.
“The real exchange rate is what matters for trade and global competitiveness so it should wash out,” Professor McKibbin said.
RBA wants a lower dollar
RBA governor Philip Lowe recently said he would like a lower currency to help lower unemployment and lift inflation, but he admitted it was “hard to argue” the currency was overvauled because commodity export prices were high and Australia had handled COVID-19 better than most countries.
Frontier Advisors principal consultant and former RBA economist Philip Naylor reiterated Nobel laureate economist Paul Krugman’s 1998 quip that “monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible”.
“There may be differences in what the Fed says, compared to what they do,” Mr Naylor said.
“That is, it may be optimal for the Fed to change people
s expectations now about future policy actions,” Mr Naylor said.
“However, when push comes to shove, it may not be in the Feds best interests to follow through on that promise in the future when prices start rising,” Mr Naylor said.
“Therefore, investors should be cautious about being too precise in their thinking about how policy changes like these may affect the future course of actions by central banks.”
NAIRU ditched
The Fed’s Mr Powell also jettisoned the non-accelerating inflation rate of unemployment (NAIRU) tool that was traditionally used to determine when a low jobless rate may generate wage and inflation pressure to necessitate lifting borrowing costs.
Former RBA and Fed official Peter Tulip said by lifting inflation expectations the Fed was trying to squeeze more stimulus out of its extraordinary asset purchase program.
“They are looking for ways to credibly argue that policy will be lower for longer and they will worry less about inflation when the unemployment rate is low,” said Mr Tulip, now the Centre for Independent Studies’ chief economist.
The Fed’s new average inflation target sounded like the RBA’s stated goal of an inflation rate of 23 per cent, on average over time, but in practice the RBA did not try to make up for past inflation undershooting, Mr Tulip said.
“The language is very similar but the RBA ‘lets bygones be bygones’,” Mr Tulip said.
GSFM’s Mr Miller warned toleration of temporary price overshoots could mean “conditions are ripe” for a resurgence of inflation like the 1970s.