Jonathan Reeves

As it tries to find a way out of its debt ceiling crisis and the economic doldrums, a consequence of US policy is that inflation is being exported to the world, and that includes Australia.

Unlike the European Union, or indeed any other enterprise in the world, the US Federal Reserve has the unique ability to print more US dollars if it – and the US Treasury – deems that this is in the US economic interest.

We have had QE1, we have had QE2, and as a result of the debt ceiling compromise we may well also have QE3. The US debt deal includes major fiscal cut-backs, increasing the likelihood that the US will continue to rely on heavy monetary stimulus in its post GFC recovery phase.

It is a policy which is keeping the value of the greenback down and contributing to the record high values for the Australian dollar, a factor which is not necessarily good for our economy. Just ask the Australian education, tourism and manufacturing sectors how they are faring right now.

Inflation is a global issue and the Americans are only one, albeit large, factor in fuelling its momentum. Energy costs are rising, as is the cost of food around the world.

The reality is that US policy has intentionally devalued the $US through the mass printing of money, putting substantial pressure on the AUD$ exchange rate and the Reserve Bank’s inflation and interest rate policy.

Currently, the RBA has an inflation target of between 2 and 3 percent. Referring to this target has been a major reason why the RBA’s official cash rate have progressively risen to 4.75 percent. With a widening interest rate differential it is no surprise that the $AUD has climbed so high against the greenback, as speculators pile into a currency which – like the Brazilian real – is one of the hottest in the world right now.

All this calls into question the wisdom of the RBA’s target inflation numbers. The 2 to 3 percent per annum target is far too low in the current economic climate, and adhering to it can only exacerbate the developing exchange rate, interest rate and export issues we are currently experiencing.

Instead, the RBA should raise its inflation target to 4 percent, a move which would help us avoid some of the economic problems we have seen internationally. Raising the target would certainly take some of the pressure off the RBA to raise interest rates, and it would also take some momentum out of the $AUD’s strength.

Mining magnates may be sitting on unprecedented wealth, but a look at the rest of the economy shows that personal debt levels are at record levels – comparable to struggling economies such as Ireland. Raising rates to fight inflation would create significant financial distress and prompt sharp falls in property values, further dampening already fragile consumer and business sentiment.

Inflation at 4 percent would assist in reducing debt levels, as it did in World War II following the Great Depression.

It seems that the RBA may be mindful of this, despite maintaining its current inflation targets. Earlier this month RBA Governor Glenn Stevens said the board believed “it was prudent to maintain the current setting of monetary policy” in view of the “acute sense of uncertainty in global financial markets over recent weeks.”

The RBA has not raised rates since November 2010, and inflation has been creeping upwards and currently sits at 3.6 percent. Officially amending the inflation target would take the wind out of ongoing expectations of a rate rise and could prompt some easing in the value of the $AUD.

At 3.6 percent, Australian inflation is not high by current international comparisons and does not pose as much of a threat to our economy as record highs for the currency. Given two “evils” – inflation or an appreciating currency – it is clear that our current level of inflation is by far the lesser evil of the two.

In fact, tolerating a higher level of inflation could be the key to helping Australia navigate the turbulence of the global economy.

Dr Jonathan Reeves is a financial economist at the Australian School of Business at the University of New South Wales.

A version of this opinion piece appeared in the Australian Financial Review on the 9 August 2011.

Professor Fariborz Moshirian

The politicised handling of the US debt ceiling cap has highlighted its implications for global financial stability, the US interest rate and the pace of economic growth. This  is contributing to the gradual emergence of a new global financial landscape in which the US dollar may no longer remain the key world reserve currency in the medium term. In addition the US dollar could decline in value, and less foreign capital move to the US. Euro zone countries and some Asian countries, particularly China, appear to be the main beneficiaries of this gradual change in the structure of the International Financial System.

Given the slower than expected US economic growth and the high level of unemployment, investors are aware that US government revenue may not increase fast enough to tackle the size of the US government debt in the medium term. Some of the current investors may well move away from US denominated assets over time. One scenario could be an increase in US bond yields, as a way of encouraging more investors to hold US treasury bonds. However, this in turn may reduce the pace of economic growth in the medium term. On the other hand, if investors shy away from US assets, another scenario could be that the US dollar should substantially decline to ensure that the US can significantly increase her exports and reduce her imports as part of repairing her budget deficit in the medium term.

China is the largest US bondholder. She has kept purchasing US bonds, partly because this will keep US interest rates lower and ensure stronger economic activity. This in turn will assist China’s exports to the US and also ensure that China’s largest debtor maintains her capacity to repay her loans.  However, China is no longer buying US treasury bonds (ie with 10 years or more maturity) but has been investing in US treasury bills and notes with short term maturity instead, as China diversifies her international portfolio and allows for greater flexibility to exit from US denominated assets.

In the short term, there is no alternative to the US dollar as the most important world reserve currency. Nevertheless, investors have already refocused their attention to short and medium term assets of emerging countries such as Brazil, China, India that appear to be secured at least in the foreseeable future. In the meantime, the debt ceiling crisis in the US has provided an incentive to both the European and Chinese leaders to create a more secured investment environment for foreign governments, companies and large private investors to redirect some of their US denominated assets into European and Chinese denominated assets. The Euro and China’s Yuan, in the medium term, may well take away a portion of the current 61 percent share of the US dollar foreign exchange reserves and also calve into the current 84 percent of foreign exchange transactions that are generally trades of national currencies for the US dollar.

BRIC (Brazil, Russia, India, China) promoted a global currency away from the US during the recent GFC. However, in the process of negotiations within the G20 for “ strong, sustained and balanced” economic growth, such an idea was not pursued. However, the recent US debt ceiling crisis has highlighted the potential for the IMF Special Drawing Rights (a basket of four major currencies) as one of the mechanisms to diversify the current world currency reserves. BRIC and South Africa have entered into a swap agreement amongst themselves so that they can settle some of their major trades without the use of the US dollar.

While China’s Yuan is not yet a major international currency, the way the debt ceiling cap in the US has been handled may encourage China to fast track the process of converting Yuan into a trading currency, an investment currency and finally a world major reserve currency. The Bank of China is active in accepting Yuan-deposit accounts in the US. Thousands of Chinese companies are using Yuan for their cross border settlements. The Yuan denominated “dim sum” in Hong Kong is used by and increasing number of foreign firms.

The recent sovereign debt crisis within the Euro-zone has been used as an opportunity for Euro-zone leaders to tackle the mismatch between a European monetary policy and  nationally based fiscal policies. Undoubtedly, a number of financial challenges still need to be resolved in Europe.  The recent support by Germany to finance the European Financial Stability Fund generously and make this fund an active source of credit for the various needs of the member countries, has provided a new impetus for the Euro as a credible currency and may well accelerate the process of the emergence of Euro bonds, supported by all Euro-zone governments, as secured and effective assets that can directly compete with US treasury bonds.

The current political debate in the US regarding the debt ceiling cap has created a new global financial landscape that will gradually lead to a more diversified world currency reserve, away from the US dollar as the dominant one. Depending on the way US economic growth and unemployment rates evolve in the medium term, foreign investors may move away from US denominated assets and pave the way for the gradual emergence of a new international financial system with a world currency that is independent from any national government’s  fiscal, monetary and political policies.

Fariborz Moshirian is Director of the Institute of Global Finance and Professor of Finance at the Australian School of Business, UNSW.

A version of this opinion piece first appeared in the Australian Financial Review on 3 August 2011.