AUD/USD Monthly Fundamental Forecast – September 2016

The AUD/USD closed the month at 0.7517 just at the price desired by the RBA which lowered rates this past month.  The RBA, along with most central banks of advanced countries, would actually like to see more inflation, not less. Annual output growth is struggling to reach 3%, which is below the long run average of 3.5%. Hence nominal GDP growth is below the 5.5% long-run average that Xenophon would target. So whether the RBA targets inflation or nominal GDP growth doesn’t matter – the policy would be the same – that is, stimulate spending by lowering interest rates, which is exactly what it has been doing.

Another downside is that although nominal GDP growth would be more stable, inflation would tend to be more volatile. Inflation could jump up and down, but as long as output growth moved in the opposite direction the RBA would do nothing to dampen the volatility in inflation. Volatile inflation increases the uncertainty about future prices, which inhibits investment spending by firms and households.

A bigger problem with the RBA’s inflation target that would not be resolved by adopting a nominal GDP target, is that the inflation target only refers to prices of goods and services – it ignores asset price inflation. The rapid rise in house prices in Sydney and Melbourne in recent years is a potentially serious problem that has been essentially ignored by the RBA. A better idea than nominal GDP targeting would be to include asset prices as well as the prices of goods and services in its inflation target

China – in particular its exchange-rate policy – could end up having a significant impact on currency markets in 2016. This also marks a new stage in the global currency war, since central banks across the industrialized world, which had been expecting to finally be able to adopt a more hands-off approach, are now compelled to respond yet again. This raises the question as to what extent the Fed can raise its policy rate and what other measures the ECB could implement to prevent the still-vulnerable Eurozone from fighting a rear-guard action in this global currency war. Governments and their central banks have long abandoned the global policy coordination introduced in 2008, the reassuring words heard at the past few G20 summits notwithstanding. It would seem that, where currency markets are concerned, nothing is certain but great volatility, to paraphrase the famous words of Benjamin Franklin.

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