NSW Waratahs boss McKenzie had previously stated his ambition to lead the Wallabies but has had a change of heart due to a desire to further his career with the Sydney-based franchise.
"It's a very big decision for me to make and one that I did not take lightly," he said.
"But when the Wallabies (players) joined the rest of our squad on the country tour last week, I came to the realisation that I was part of something special and that I could become a much better coach by staying at NSW and finishing what I started two years ago."
The Australian Rugby Union respect McKenzie's decision, and are still adamant they will hire the best possible candidate for the national coaching role.
ARU chief executive Gary Flowers has also quashed reports suggesting the Wallabies' new coach will only be selected from a list of Australian candidates.
"Ewen (McKenzie) was certainly a strong candidate but he is not the only candidate," Flowers said.
"That includes Australians coaching offshore or non-Australians.
"We have said from the outset that we have an open mind on the issue of overseas coaches, although our preference is for an Australian."
McKenzie has signed a lucrative contract with the Waratahs that will tie him to the Super 14 team until the end of the 2008 season.