It may be time for the RBA to throw out the economics textbook

Photo: STR/AFP/Getty Images.

Australia’s economy is humming, at least according to the March quarter GDP report released by the Australian Bureau of Statistics (ABS) earlier this month.

At 3.1%, the year-on-year figure stunned markets and economists alike, coming in above the level many deem to be Australia’s “new” trend growth rate.

Yet, inflation is nowhere to be seen.

Over the same period, core inflation came in at just 1.55%, according to figures released by the ABS, the lowest annual increase ever recorded.

Growth is above trend, while core inflation is printing at record lows. It’s not quite baffling enough to see Scully and Mulder from the X Files come out of retirement to investigate, but it’s unusual nonetheless.

Falling terms of trade, record-low wages growth, technological advancements, among others, have all been cited as catalysts to explain the divergence between price pressures and growth.

To Morgan Stanley’s global FX strategy team, led by Hans Redeker, there is another factor that has been contributing to the decline in Australian inflationary pressures, and one that may lead to significantly weaker Australian dollar in the second half of the year.

China, and its currency, the renminbi.

He explains.

Despite USDCNY breaking higher, RMB’s onshore/offshore spread has remained stable, suggesting that there is little capital outflow pressure. Stable capital flows suggests authorities are continuing to allow the RMB to trade steadily lower. It is the release of disinflationary pressures via the RMB depreciation currently running at an 11% annualised rate that’s pushing inflation rates of China’s main trading partners lower. Here we see Australia especially exposed.

Essentially, by weakening its currency, Chinese authorities are placing downward pressure on the cost of Chinese goods exported around the world, adding to disinflationary pressures in other nations, including Australia.

Should that trend continue, Redeker believes it may lead to an aggressive policy response from the RBA in attempt to lift inflationary pressures.

“The RBA may soon have to admit that textbook economics –- namely domestic growth leading domestic inflation –- no longer applies within an increasingly global world,” says Redeker. “(It) may soon have to repeat the experience the Riksbank had in 2014 when growth did not help inflation. In 2014, SEK fell hard. The second half of 2016 may see AUD weakening significantly.

When Redeker refers to the Riksbank, he’s talking about the Swedish central bank, and its currency, the krona.

Back then, in an attempt to boost inflationary pressures, the Riksbank cut rates aggressively (they’re now below zero and QE is also being undertaken) despite relatively strong levels of economic growth.

In response, the krona fell out of bed, plunging by 40% against the US dollar, and around 10% against the euro, over the preceding 12 months.

Although many believe that a lower Australian dollar would be helpful, few, if any, believe that the RBA would resort to such drastic measures to lower the currency.

When it comes to an economic outlier, it’s past Pluto on an interplanetary scale.

However, few believed that Australia’s cash rate would ever fall to 1.75%, and yet here it is. Now almost everyone expects that it’ll be reduced even further within six weeks.

And yet the Aussie dollar continues to remain bid, no matter what is thrown at it. And markets already have at least one rate cut, maybe two, priced in.

If there’s one thing that we’ve all learnt over the past eight years, it’s to expect the unexpected when it comes to central bank policy.

Just ask the Fed, ECB, BOE, BOJ, SNB and Riksbank, among others.

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