If Treasurer Joe Hockey was smart, he would be starting to link the fiscal tightening that seems to be in store in the budget to the current low interest rate environment and he would suggest the fiscal austerity about to be unleashed is a deliberate policy effort to try to drive the Australian dollar lower.
There is no doubt that there is a trade off between fiscal and monetary policy. Whenever fiscal settings are tightened, interest rates can be held lower than they would otherwise be and vice versa. The current low level of interest rates owes something to the tightening in budget policy over the last couple of years.
With this starting point rule of thumb, any significant net withdrawal of cash from the economy by the Abbott government via the budget will lead to slower growth and a lower level of employment than would otherwise be the case. That part is simple.
The effect on inflation from fiscal tightening is more difficult to fully articulate but it is clearly restrictive and as a result, a very tight budget could have the same effect on the real economy as an interest rate hike, or two, but without interest rates going up – obviously.
For the Australian dollar, the maintenance of low interest rates when there has been growing speculation about interest rate increases, would mean a moderate dampening bias to the recent uptrend. While the Aussie dollar and all currencies are driven by a lot more thinks than interest rate settings, a lower interest rate structure in Australia would take a little gloss off an otherwise upbeat view.
Of course a fiscal tightening would likely reinforce Australia’s triple-A credit rating which might act to increase demand for Australian dollar denominated assets, but given that the triple-A rating is already in place, this effect is likely to be less dramatic than, say, an interest rate hike.
Mr Hockey is smart and while he doesn’t want to fire off too many shots before the fine detail of the budget is finalised, if in fact we do see a decent fiscal tightening on budget night on 13 May, expect Mr Hockey to come out and say that the tight budget will keep downward pressure on interest rates. He will link this to his jawboning of the dollar and with a little bit of good luck, this might take some shine off the Australian dollar.