Up and down under: as a benchmark for inflation, the australian dollar is at least as good as gold

As a benchmark for inflation, the Australian dollar is at least as good as gold.

IF Hillary Clinton were to resume commodity trading in order to finance her husband's 1996 election campaign, she would probably be accumulating a long position in gold contracts. But if she wanted to speculate on a revival of inflationary psychology in the financial markets, she would diversify her portfolio by adding a large long position in contracts for the Australian dollar. If she encountered Alan Greenspan at a Washington cocktail party, she could tell him that he should focus more attention on the Australian dollar when setting U.S. monetary policy.

Most Americans would probably be startled by the suggestion that their central bank would have anything to learn from monitoring the currency of the sunburned continent of kangaroos and Crocodile Dundee. Yet the Australian dollar provides far more useful information about global inflation expectations and the psychology of bond markets than any of the G-7 currencies or even gold. The yen skyrocketed during 1994 and early 1995 because Japan's closed economy produced a massive trade surplus which the country's bankrupt financial institutions found difficult to recycle into foreign securities. The German Mark rose to new highs last year because of capital flight from the high-debt/weak-government countries of southern Europe. Gold also has become a potentially confusing indicator because it is very sensitive to political events in South Africa (which produces one-fourth of world output) and the rising real income of China and India (which already consume one-third of new world production).

The Australian dollar has proved to be a far more reliable proxy for global inflation expectations. In the floating-exchange-rate era, its movements have correlated closely with commodity prices, and they have often been a good leading indicator of changes in the level of U.S. interest rates.

Why does the dollar from down under enjoy its unique status as a surrogate commodity basket? Over two-thirds of the country's exports consist of wool, wheat, iron ore, coal, bauxite, and other base metals. Commodity-producing companies also account for about one-third of Australia's stock-market capitalization, compared to less than 5 per cent in most industrial countries. When commodity prices rise, Australia's trade account improves and capital flows to purchase the shares of commodity-producing companies expand, boosting the currency. When commodity prices fall, these flows reverse.

THE Australian dollar's performance provides a useful illustration of how its exchange rate vis-a-vis that of the U.S. dollar can be a guide to inflationary psychology. The Australian dollar fell to a seven-year low of 65 cents (U.S.) during the first half of 1993 because of investor concern about how sluggish world economic growth would depress commodity prices and Australian export earnings. But it rose steadily during 1994 to a peak of 77 cents on the back of robust economic growth in the U.S. and a recovery in world commodity prices. When Fed tightening started to slow the U.S. economy in early 1995 and commodity prices corrected, the A-dollar confirmed the reduced risk of inflation by dropping back to 71 cents. As a result of Fed easing, the U.S. economy improved during the third quarter of 1995 and the Australian dollar rallied back to a range of 73 to 74 cents.

Should the Federal Reserve and the U.S. Treasury announce a formal exchange-rate target for the Australian dollar in order to reassure global bond investors that they finally have a coherent strategy for restraining inflation and avoiding deflation? Probably not. Whenever central banks announce new policy targets, investors immediately adjust their behavior in ways that undermine the targets. When central banks had formal money-supply targets, investors shifted their savings to financial assets not included in the official monetary aggregates. When European central banks introduced exchange-rate targets during the late 1980s, investors aggressively purchased the currency with the highest yield and thus made it difficult to hold exchange rates within their official target bands.

So, instead of publicly announcing a formal target for the Australian dollar, Federal Reserve officials should simply refer to the currency as a useful market indicator in the same way they do currently with gold, other commodity prices, and bond yields. Since Alan Greenspan recently came out of the closet to reveal his long-standing affection for gold as a monetary indicator, many goldbugs and hard-money fanatics would probably be disillusioned by such a gesture. But the goldbugs have to adjust to the changing geo-economic and political realities of the yellow metal. Can gold serve as a U.S. monetary anchor when the dowries of Chinese and Indian brides could soon be consuming one-half of world output? Should the U.S. have a monetary compass in which a major political risk factor is Winnie Mandela? Or would it be wiser to take its chances with Bernie Fraser, the Governor of the Australian Reserve Bank?