July 29, 2019

Australian Markets Weekly: The impact of the exchange rate on GDP

Our analysis suggests that the real exchange rate has more of an impact on growth than earlier RBA analysis.

For the full picture, download the report – Australian Markets Weekly 29 July 2019.

  • In a 2016 analysis, the Reserve Bank calculated that, all else equal, a 10% drop in the real exchange rate boosted exports by about 3% and reduced imports by just under 4% over a two-year period. On current trade shares, these effects would boost real GDP by about 1½%.
  • Updating that work, our analysis suggests that the effect on GDP of a 10% fall in the real exchange rate is larger when the impact on trade is estimated over recent history. We estimate that the lower exchange rate lifts exports by about 3.5% and reduces imports by about 7% over a two-year period, where imports have become more sensitive to the currency over time. Using current trade shares, this would boost GDP by about 2¼%.
  • The results reinforce our view that a lower exchange rate would be helpful for the Reserve Bank as it seeks to return inflation to the 2-3% target band. Unfortunately, the bank is unlikely to see any relief on this front as our FX strategists forecast an appreciation in the nominal exchange rate over the coming year, mainly against the US dollar (this reflects further US dollar weakness, commodity price resilience and current market pricing for interest rates). This suggests that lower rates and additional fiscal stimulus will be needed instead to support the economy.

The week ahead – Australian Q2 CPI and the US FOMC meeting the major focus

  • Core inflation is expected to remain subdued in Q2. We forecast the RBA’s preferred measure of core inflation – the trimmed mean CPI – to increase by 0.4% in the quarter, which would see annual inflation ease to 1.5%, matching the multi-decade low reached in 2016. Headline inflation should also increase by 0.4%, up 1.4% over the year, with the risk it might be marginally higher than our estimate. If our forecasts prove correct, the Reserve Bank will be under pressure to downgrade its near-term outlook for inflation in the August Statement on Monetary Policy. Retail trade should improve in June, up 0.5%, although the quarter should be weak, with a marginal increase of 0.1% in volume terms. Note that next month’s retail trade report for July should be boosted by the government’s personal income tax cuts.
  • Internationally, the FOMC is expected to cut the funds rate by 25bp to 2-2.25% on Wednesday and signal a preparedness to do more. Data-wise, the US manufacturing ISM is due Thursday, with payrolls on Friday. China PMIs are also due Wednesday.

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