Fed taper puts RBA rate cut on ice

One effect of the US Federal Reserve’s “taper” is that the Reserve Bank of Australia might soon abandon its leaning towards lower interest rates.

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The taper is the popular term for the gradual winding down of the central bank’s so-called “quantitative easing” (QE) of monetary policy.

But with the US economy now showing signs of life, the Fed has decided to start to wind back QE, which currently involves the Fed buying, every month, $US85 billion of US Treasury bonds and mortgage-backed bonds issued by US government-sponsored agencies.

It won’t stop bond purchases altogether, let alone start selling them back to the private sector, but will cut its bond buying to only $US75 billion a month, from January.

It’s not much, but it’s a start.

It means interest rates will drift higher.

As far as short term interest rates are concerned, the Fed said it will stick with a near-zero federal funds rate – the equivalent of Australia’s cash rate – until “well past the time that the unemployment rate declines below 6.5 per cent”.

The jobless rate in the US was last measured at 7.0 per cent and economic growth is still only “moderate”, so a higher fed funds rate is many months away, most likely in 2015 or later.

But higher short-term rates are coming, even if not for a while.

That spells the beginning of the end of a key support for the Australian dollar since the global crisis erupted in 2008 – a positive gap between Australian and US interest rates.

It’s only a small beginning – in fact the gap hasn’t even moved yet.

But markets are forward-looking.

The expectation that the interest rate differential will narrow can have the same effect as the reality of it.

That can be already seen in the foreign exchange market.

When the Fed first flagged the possibility of the taper earlier this year, the Aussie slid from over 105 US cents in April to below 89 in early August.

Subsequent news that the Fed had delayed the taper pushed it up to over 97 US cents again.

Since then, the growing expectation that the taper was back on the agenda, and the confirmation on Thursday that it indeed was, has helped to bring the Aussie back below 89 again.

That should help to alleviate the RBA’s well-known frustration with the “uncomfortably high” Australian dollar, which has been sapping the Australian economy’s strength by undermining the competitiveness of local industry.

That in turn will make the RBA less willing to cut interest rates further to give the economy an offsetting boost.

The lower the Aussie goes, the less pronounced the RBA’s “easing bias” will be.

And if the Aussie heads into the low 80s, you can probably kiss any chance of more rate cuts goodbye.