MNI ANALYSIS: Strong AUD's Burden on Wages Key for RBA Policy

--RBA Statement Friday Important for Comments on AUD Impact On Competitiveness

By Sophia Rodrigues

     SYDNEY (MNI) - It's widely agreed that the Reserve Bank of Australia won't

shift its current neutral monetary policy stance anytime soon because of the

risks this would pose to household balance sheets but an insight into how the

stance could start to tilt towards easing is likely Friday when the quarterly

Statement on Monetary Policy (SOMP) is published.

     The RBA has already said its forecasts for the economy will remain largely

unchanged, and while this is important, the key part of the document will be the

central bank's commentary on the exchange rate. 

     The RBA already provided a hint on what could be expected by devoting four

lines in Tuesday's cash rate statement to discuss the elevated exchange rate and

the impact it could have on output, employment and inflation if it remained

strong.

     The impact would be much greater because the Australian dollar's strength,

as the RBA pointed out, is "partly reflecting a lower U.S. dollar." It is not

entirely due to a rise in commodity prices even though it is clear even an

appreciation related to rise in terms of trade could still have a dampening

effect on growth and inflation.

     The August 1 statement was the first time in recent memory that the RBA

discussed the exchange rate in such detail in a cash rate statement. But

detailed commentary in the SOMP is not uncommon. 

     What is likely to be different this time is the way the RBA characterizes

the risk with respect to wage growth, which has been its top area of concern.

     The risk is that an elevated exchange rate could further erode Australia's

competitiveness, thus putting more pressure on labor costs to retain any

competitive edge. But downward pressure on wages is a big risk given the

importance of wage growth to the central bank's forecasts for both inflation and

growth.

     During the run-up in the terms of the trade which peaked in 2011, wages

grew strongly and the exchange rate appreciated, resulting in a decline in

international competitiveness of Australia's labor. Since the fall in the terms

of trade began a few years ago, the adjustment in the economy happened via two

key channels - the depreciation of the exchange rate that began in 2013 and the

slowing in wage growth. Unit labor costs in Australia have been little changed

since the terms of trade peaked in 2011.

     A RBA bulletin article published in March discussed this in detail. "Since

the terms of trade have been declining, low growth of wages has played the

reverse role of improving international competitiveness, in conjunction with the

depreciation of the exchange rate," 

     In a special article in the May SOMP, the RBA further said, "By any

measure, Australia's real exchange rate has depreciated since the end of the

terms of trade boom. This has helped the economy adjust to the significant

reduction in income from the terms of trade decline and the associated fall in

mining investment by boosting activity in the tradable sector."

     "An appreciating real exchange rate would complicate that adjustment," the

RBA warned.

     To retain competitiveness amid an elevated exchange rate, wages would need

to slow further. But that is a worst-case scenario for the RBA, which is banking

on a recovery in wage growth.

     At the Q&A session at the Anika Foundation luncheon last month, RBA

Governor Philip Lowe also stressed the importance of a low exchange rate in

maintaining competitiveness.

     The solution to the competitiveness problem - if there is a problem - isn't

lower and lower nominal wage growth. "It largely rests on the exchange rate," he

said.

     "The competitiveness pendulum swings with the exchange rate. In principle,

if we thought why we weren't sufficiently competitive, then a lower exchange

rate would be helpful," he added. 

     A lower exchange rate would help generate more jobs, push inflation closer

to the RBA's target, he said. "So, that's the solution to a competitiveness

problem, not grinding low wages growth at the aggregate level."

     Lowe's emphasis on why wages cannot be pushed lower is an indication of how

concerned the RBA would be if the burden for maintaining competitiveness fell on

wages. 

     In Tuesday's cash rate statement, the RBA said, "One source of uncertainty

for the domestic economy is the outlook for consumption. Retail sales have

picked up recently, but slow growth in real wages and high levels of household

debt are likely to constrain growth in spending."

     The RBA's concern over low wage growth was also evident in its commentary

on the labor market, where despite the recent positive development in employment

growth and expectation of a further decline in the jobless rate, the RBA pointed

toward the fact that "wage growth remains low and this is likely to continue for

a while yet."

     So if the exchange rate remains high and its dampening impact becomes

evident, the risk is that the RBA may have to ease monetary policy further.

     As a 2012 paper published by the Australian Treasury noted, "Should the

exchange rate become too high for macroeconomic purposes, this will be reflected

in rising spare capacity and, ultimately, declining inflation. In these

circumstances we could expect that monetary policy would be eased, putting

downward pressure on the exchange rate."

--MNI Sydney Bureau; tel: +61 2-9716-5467; email: sophia.rodrigues@marketnews.com

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