Gains in Australian Dollar Places Central Bank in Difficulty

Market Trends - 26/10/2016

While the Australian dollar is higher versus the US dollar following a bigger than anticipated rise in consumer price inflation, optimism from Australian officials may be limited.  For years, policymakers at the Reserve Bank of Australia (RBA) have been slowly cutting interest rates.  The strategy was designed to fight strength in the Australian dollar and make exports more competitive in a difficult trade environment.  While the efforts have largely been successful, the latest inflation data may hamper further progress.  With inflation increasing by 1.30% over the same period a year earlier, it is rapidly closing in on the 2.00-3.00% targeted by the Central Bank.  As inflation rises, falling interest rates could create problems by accelerating the gains in inflation.  This strategy could potentially cause inflation and the economy to overheat.  As such, expectations for another rate cut during the second quarter of 2017 are now more distant, helping the Australian dollar rise from current levels.

One of the goals of lower interest rates was reducing the value of the Australian dollar.  Besides making the currency more competitive when it comes to trade, a falling currency raises the costs of imports, pressuring inflation higher.  While the RBA has targeted a weaker exchange rate for the currency, should inflation continue to rise, the Australian dollar may mirror the gains.  If inflation reaches the target the Central Bank is unlikely to lower rates further, adding to optimism that the currency will continue to rise against peers.  However, a stronger Australian dollar could create ripple effects throughout the economy and reduce competitiveness in international trade.  As such, the RBA is hoping the US Federal Reserve will help to lessen the pressure on the Australian Central Bank by raising interest rates.  Any upward movement in US interest rates will likely fuel a continued rally in the US dollar, helping AUDUSD fall and the RBA meet its exchange rate objectives.

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