Australia | May 09 2016
– Inflation drives rate cut
– Australian economy healthy
– Little currency relief expected
By Greg Peel
The RBA’s cash rate cut to 1.75% last week caught many in the market by surprise, not the least forex traders. On the announcement, the Aussie plunged from above US76c to US75c in a heartbeat. Subsequent unrelated strength in the US dollar drove the currency further south to US74.5c.
While the RBA highlighted lower inflation expectations as the major reason for the cut, a persistently strong Aussie dollar has been cited by the central bank for the past couple of months as providing a “complication” as Australia attempts to transition away from reliance on mining investment. It is assumed, therefore, the cut was also delivered in the hope of affecting currency weakness.
The RBA’s Statement on Monetary Policy, released on Friday, saw a cut in the central bank’s 2016 inflation forecast to 1-2%, suggesting the target 2-3% band will not be reached this year. The Aussie has since fallen to US73.5c.
Commonwealth Bank’s economists have acknowledged that the rate cut has put some pressure on the currency, but do not believe it will ultimately be a lot. Indeed, CBA is forecasting an exchange rate of US75c at the end of June and US$78c at the end of the year, unchanged from prior forecasts.
It is important to make the distinction, CBA suggests, that the RBA did not cut its cash rate because the Australian economy is weak. It cut because inflation pressures “were unexpectedly low”.
We are reminded that for several months prior to May, Glenn Stevens’ policy statements all ended with the sentence “Continued low inflation would provide scope for easier policy, should that be appropriate to lend support to demand”. Clearly the shock March quarter CPI result, showing disinflation, provided sufficient scope.
The rate cut was then appropriate because the Aussie dollar was frustrating strong, and because earlier constraint from fear of fuelling a housing bubble had been tempered by stricter lending restrictions. Moreover, prior assumptions of ongoing US rate rises have so far proven unfounded, and Japan and much of Europe have cut rates into the negative, suggesting an RBA rate cut was necessary just to bring local rates into line with global policy settings.
And in so doing, take pressure of the Aussie dollar.
CBA points out that the Reserve Bank of New Zealand has delivered 125 basis points of rate cuts – equivalent to five RBA cuts – since June last year and over that period the NZ dollar is only US2.5c lower.
One problem is that lower inflation actually supports a currency. Exchange rates are more sensitive to movements in real interest rates, CBA points out, meaning the nominal rate minus the inflation rate. If the inflation rate falls the real interest rate rises, hence the currency rises.
In Australia’s case, the Aussie has not remained elevated simply because of the differential to a weaker US dollar, but because the Australian economy is actually looking moderately but relatively solid. The unemployment rate is trending lower and the trade deficit is also falling. Rising commodity prices, fresh LNG exports and lower debt-servicing requirements due to the lower cash rate will all drive improvement in Australia’s current account deficit, CBA notes, which is supportive of the currency.
At this stage the CBA economists are assuming the Fed will hike again in June, or maybe July, which will help keep the Aussie at bay. But they don’t see too much downside. Should a series of challenging global events occur, the economists can see a drop to the currency’s 200-day moving average of US72.6c, but there it should find support.
Otherwise, CBA’s forecast of US78c by year-end remains intact.
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