THE BIG PICTURE: How US stimulus and the Australian dollar are connected

There is no doubt that there is only one game in town – one ‘hot button’ issue, if you like – and that’s quantitative easing. In essence the term refers to the printing of more money; but as you would expect economists ‘pooh-pooh’ that kind of simplification saying that it is more complicated than that. But with interest rates in the US effectively at zero and concerns that the economic recovery is at risk of stalling, many of the US Federal Reserve members believe that another round of quantitative easing – or QE2 – may be necessary.

In the first round of QE, the Federal Reserve bought US$1.7 trillion of mortgage-backed securities and Treasuries. Now Federal Reserve policymakers say that another round of QE may be necessary “before long” – they are just working out how much will be needed and how they should explain what’s going on. Of course the Fed didn’t actually say it like that; it said they “wanted to consider further the most effective framework for calibrating and communicating any additional steps to provide such stimulus.”

As mentioned, economists don’t like to use the term “printing money” to describe quantitative easing. They prefer to say that the Federal Reserve is making use of its balance sheet to apply more stimulus to the economy. But when you buy securities from financial institutions in exchange for cash, that cash has to come from somewhere.

How did the Fed get to this situation? Well it’s largely because it has fired all their traditional bullets. That is, interest rates are near zero – the range for the federal funds rate is between zero and 0.25%. If the Fed believes the economy requires more assistance to get going, there is not much else it can do.

Note that Federal Reserve chief, Ben Bernanke, has done a lot of research on the Great Depression and is determined that the economy avoids going down that path. Bernanke famously goes by the title “Helicopter Ben”, after a speech he gave in 2002 where he said that deflation (falling prices) should be avoided at all costs even if it required the government to drop money from a helicopter to get people spending.

Will it work? The problem is that you can put dollars in people’s pockets but that doesn’t mean they have to spend. Corporate America is already sitting on US$2 trillion of cash (in a US$14 trillion economy) but they aren’t confident to employ or invest. Companies want certainty – that is, if they do start to do business again, that the rug won’t be pulled from under them. In other words, that policy won’t go from ‘loose’ to ‘tight’ too quickly.

What are the risks? One risk is that it doesn’t work, undermining confidence. But there is another risk – it works too well – that all that extra money in the system creates inflation. With inflation near 1% currently, that is not a risk. Of course all those extra US dollars in the system reduce the value of the currency and that means other currencies like the Australian dollar go up. Our currency strategists believe that is just a matter of time before the Aussie dollar goes beyond parity with the greenback, and a key reason is QE.

The week ahead

The Reserve Bank seems to hog the spotlight most weeks and the situation is no different in the week ahead. The Reserve Bank releases minutes of the last Board meeting on Tuesday, and given the brevity of the statement released immediately after the meeting, analysts will be scouring the latest document more closely than normal.

The interest rate announcement gave few insights into the Reserve Bank’s thinking on the Australian economy, especially key issues like the tight job market, consumer spending and the housing market. If the Reserve Bank believes that the economy is patchy, with inflation likely to remain in the 2-3% target band, then it won’t be in a rush to change policy settings.

In terms of economic data, there are no ‘top shelf’ items on the calendar. Car sales figures are released on Monday with skilled vacancies, private sector wealth and imports on Wednesday. Reserve Bank Head of Financial Stability Department, Luci Ellis, is a panel discussant at the Finsia Annual Financial Services Conference on Wednesday. And data on export and import prices is released on Friday.

Car sales have proved quite healthy with more than a million vehicles sold in the past year. But a key influence has been last year’s tax break with deliveries of vehicles still trickling in. Car dealers were telling clients late last year that deliveries could take up to a year for custom vehicles. But low car prices are also an attraction for budding buyers, with lower tariffs and the firmer dollar the key influences.

The data on private wealth will probably show some stabilisation with lower share prices offsetting higher home prices. Wealth is at record highs, highlighting the good position of household balance sheets.

In the US, a consistent flow of indicators awaits investors over the coming week. On Monday industrial production figures are released together with capital inflows data and the NAHB index. Housing starts are slated for Tuesday, the Federal Reserve Beige Book is issued on Wednesday, while both the Philadelphia Fed index and leading indicator report are released on Thursday.

Industrial production probably lifted by 0.2% in September, confirming that the economic expansion is continuing, but at a more modest pace. But housing starts probably eased for the first time in three months with activity showing further signs of settling just below a 600,000 annual rate. And the leading index probably lifted by 0.3% in September, matching the gain in August.

There will be plenty of interest in the views of Federal Reserve officials in the coming week with no fewer than 10 speeches scheduled by Fed governors or regional presidents.

But arguably more important than the bevy of US figures to be released over the week is the latest monthly batch of Chinese data. On Wednesday China will release indicators covering production, retail spending and inflation, together with the economic growth estimates for the September quarter.

Sharemarket

The US earnings (profit reporting) season truly takes centre-stage in the coming week with a ‘who’s who’ of Corporate America set to deliver results. Amongst those reporting on Monday are Citigroup, Apple and IBM. On Tuesday, Bank of America, Coca-Cola, Goldman Sachs, and Yahoo! are slated to report. Earnings results out on Wednesday include those from Boeing, Wells Fargo and E*Trade. On Thursday, AT&T, Caterpillar, McDonalds, Morgan Stanley, Amazon.com and American Express issue profit results. And a small group of 15 companies issue results on Friday including Verizon.

Interest rates, currencies & commodities

The Aussie dollar bottomed in early June (June 7) when it fell to US81.50 cents. Since that time the Aussie dollar has risen by around 21%. Clearly these stellar gains in such a short period of time have caused many to question whether the rally is sustainable. That is, how much of the Aussie dollar gain is due to weakness of the US dollar, and how much reflects fundamentals such as higher commodity prices.

Unfortunately there is no fool-proof way to work it out. Certainly one of the best ways to assess the changes is to look at commodity prices in both US dollar terms and currency-neutral SDR terms. Since the start of June the Commonwealth Bank commodity index has risen by just over 11% in SDR terms while lifting around 20% in US dollar terms. It’s also worth pointing out that the US dollar index, which broadly measures the strength of the greenback, has lifted by around 13% over the same period.

These figures suggest that around half of the Aussie dollar gains can be attributed to commodity prices and the other half to US dollar weakness. But when the US dollar is falling, commodities become cheaper in local currency terms for buyers in Europe and Asia. So some of the gain in commodity prices would reflect greater short-term demand for a cheaper product. At the same time, the perception that Aussie interest rates are likely to rise in coming months and our strong economy would also be factors driving the Aussie dollar higher.

All that we can say with certainty is that while there is indeed a fundamental basis to the Aussie dollar’s gains, a healthy component of the rise reflects a weak US dollar. That point is important when you consider that commodity prices have only risen by 1% over the period since early June.

Craig James is chief economist at CommSec.