How the fall of the Australian dollar could affect interest rates

Australia’s economy, by international standards, is relatively small, but our dollar is among the most traded in the world.

So when it moves more than a cent or two (against a major currency like the US dollar) it tends to gain a bit of momentum.

For much of the second half of this year this has been known as the ‘range limit’ – meaning it has struggled to break out of a trading range between 72 and 74 cents. Americans.

Since early November however, the dollar has been down 75.5 cents US and is now hovering around 70 US cents.

When the dollar shows signs of significant movement in either direction, economists take note.

Dollar issues take center stage

So why do we care if the dollar moves?

Because changes in the dollar influence the prices we pay for imported products, and therefore inflation.

That is, the lower the value of the dollar, the more we need it to buy something made in another country.

“If it drops by 10%, then all things being equal, imported prices rise by 10%, and they represent around 20% of the CPI, so spread over a year, that would add 2% to the prices,” he said. declared AMP Capital. Shane Oliver said.

The dollar is falling, so if it continues to lose ground, it will add to already existing inflationary pressures.

And the higher the level of inflation, the more likely it is that the Reserve Bank will advance its first policy rate hike.

How far can he go?

Several factors influence the rise and fall of the dollar.

They include the price of iron ore, coal and gas (Australia’s largest exports); the level of Australian interest rates compared to the rates of other countries; the perceived health of the Australian economy; the large demand for currencies from other countries; and, in general, the level of anxiety in global financial markets.

Right now, commodity prices are under pressure, offshore interest rates are rising, and the pandemic is more than shaking a few nerves in global financial markets.

Fortescue Metals' iron ore train cars sit next to machinery.
The price of iron ore is a key driver of the Australian dollar. (ABC News: Rachel Pupazzoni)

As such, global currency investors view the US dollar as a “safe haven” investment and the Australian dollar is declining.

There is a realistic chance that the dollar will drop below 70 cents US, but it could just as easily stabilize where it is.

The good news

The good news is that the link between changes in the dollar and changes in import prices has not been so strong lately.

“This [the dollar] fell about 14% into the low of the pandemic last year, and inflation hasn’t come down much, ”says Dr Oliver.

“And earlier this year it rebounded to US $ 0.80, but there was little impact on inflation.

“And that depends in part on the ability of companies to pass import price increases on to their customers.”

Bad news

The less good news is that the recent fall in the dollar coincides with the surge in pent-up consumer demand, according to Dr Oliver.

Indeed, we are already seeing signs that inflation is gradually increasing and not falling.

The Melbourne Institute’s monthly inflation indicator rose 0.3% in November, or 3.1% for the year.

The “underlying” or trimmed average measure also rose 0.3% to be up 2.6% on the year.

This only adds to fears that the higher inflation we have started to see in the economy will push consumers to push ahead with their spending plans (for fear of paying more for the same item in a few months).

Unfortunately, the resulting increase in demand is also fueling inflation.

a skyline with houses
The big banks have already started to increase their fixed rate mortgages.(ABC News: John Gunn)

One to watch

The reality is that if the Australian dollar continues to fall, there is a risk that imported inflation, and more broadly inflation, will start to rise.

Westpac does not see this happening. The bank’s economics team estimates the dollar to trade at 71 cents US in March, then drop back to 70 cents in June.

The NAB economics team says “it takes at least a year” for a weaker dollar to impact a significantly higher CPI.

The problem is, the pandemic has thrown most business models out the window.

Right now, companies are passing higher production costs on to consumers, and fears that prices will continue to rise are causing many people to anticipate their purchases, further fueling inflation.

Imported inflation only adds to this.

And Dr Oliver believes the Reserve Bank will not hesitate to change its monetary policy in response.

“So if he holds up it could add pressure on the RBA to present their first [interest] rate hike. “

It’s a risk

And this is the crux. A sustained build-up of inflation will trigger a monetary tightening cycle for the Reserve Bank.

The big banks have started to increase the interest rates on their fixed rate mortgages.

In some cases, they have gone through three or four rounds of tightening in the past few months.

You can see where this leads, can’t you?

Analysts fear a scenario of a falling dollar contributing to higher and sustained inflation that would see the Reserve Bank raise the cash rate much sooner than expected.

This would push variable rates upward, which would increase the upward pressure on fixed rates.

The hope is that all of this coincides with higher economic growth and lower unemployment, but what if it doesn’t?

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