It looks like the Aussie dollar will be relatively weak in 2015, at least compared to recent history, writes University of New South Wales professor of economics Richard Holden
.

The Australian dollar is a curious currency. It is the fifth most traded in the world and it gyrates pretty wildly – having traded below 48 US cents and above 110 in the decade or so from mid 2001 to 2011. And to listen to the financial press – or the governor of the Reserve Bank – it would seem to determine our economic fortunes more than almost anything else. No wonder we are obsessed with it.

What then, does 2015 hold for the Aussie, and by implication the nation? That’s the sort of question I generally try to avoid answering – in the spirit of Nobel Prize-winning physicist Niels Bohr and baseball legend Yogi Berra who are both credited with the some version of the aphorism: “it’s tough to make predictions, especially about the future.”

But our currency has become so central to debates about everything from unemployment to interest rates to deficits that I can’t avoid throwing caution to the wind and, in an homage to President Harry Truman, doing my best impersonation of a “one-handed economist”. Truman reportedly once said “Give me a one-handed economist! All my economists say, ‘On the one hand… on the other.’”

What will determine the level of the Aussie dollar?

Here’s a good question for you. What determines the level of the Aussie dollar: (a) our terms of trade, (b) the difference between interest rates in Australia and abroad, (c) global investor sentiment, (d) whatever five hedge fund managers in Greenwich, Connecticut say it’s worth; or (e) all of the above?

I’m going with (e) all of the above. That fact makes it pretty hard to pinpoint an exact level of the dollar at any point. But it is fair to say most of those factors point to an exchange rate on the weaker side of what we’ve been used to over the last few years. The prices of what we export versus what we import (the terms of trade) have been weakening, putting downward pressure on the Australian dollar.

The US Federal Reserve has been scaling back its bond-buying program (“quantitative easing”) and the US economy grew very strongly in the last quarter, increasing the chances of an interest rate rise in 2015 or 2016. And Glenn Stevens may not be predisposed to a cut in Australian rates (in no small part because of the weakening AUD) but the fragile economy, rising unemployment, and low inflation hardly point to a rate hike.

So, from a current level of about 82 US cents, the Aussie is probably not going to spend much time above 85 and could spend a fair bit below 80 – maybe below 75.

The benefits of a weak or strong Aussie dollar

When the Aussie dollar falls, our exports become cheaper for the foreigners who buy them. Their US dollar, Pound, Yen or Euro buys more Australian dollars and hence more of our “stuff”. This increases their demand for our exports. This is good news for exporters such as the mining, education and tourism sectors.

Much less emphasised are the costs of a weaker dollar. In a piece in this publication late last year I suggested that our economy has changed a fair bit from the circa 1990 version that benefited from a lower dollar.

We buy more from overseas than we did – both consumers via the internet and increasing trade, and producers in terms of equipment and other business inputs. And a lot of the stuff we do buy has no close domestic substitutes. In information technology and electronics, particularly, we buy a lot of important things from overseas that we can’t just “not buy” and we certainly can’t get locally. When the Aussie dollar falls these purchases cost more, and they have spillover effects on our productivity.

A weaker Australian dollar makes consumers poorer and business less productive. And that matters a lot more than it used to – and, dare I say it, a lot more than whatever Dynamic Stochastic General Equilibrium model the Reserve Bank is currently using seems to tell them.

The bottom line

It looks like the Aussie dollar will be relatively weak in 2015, at least compared to recent history. A number of people think that’s a good thing. I don’t. The puts and takes I mentioned above are basically a wash. The kicker is how it affects policy.

I think that the Reserve Bank materially overestimates the benefits of a lower dollar – so much so that it seems like the lower dollar has scuppered the chance of a 50 basis points rate cut this year. That was the reaction of futures markets to Glenn Stevens’s comments about the dollar and interest rates late last year.

With low inflation, a weakening mining sector, uncomfortably high unemployment and political uncertainty, a couple of 25 basis point cuts would be a great thing for the economy.

Too bad that the bank puts so much weight on the currency – and too bad that it looks likely to be weak in 2015.

This article was originally published on The Conversation. Read the original article.