RBA’s Bullock: Inflation remains too high

The Reserve Bank of Australia (RBA) sets interest rates and manages monetary policy for Australia. Decisions are made by a governing board at 11 meetings a year and ad hoc emergency meetings as needed. The RBA’s main mandate is to maintain price stability, which means an inflation rate of 2-3%, but also “…to contribute to currency stability, full employment and economic prosperity and well-being to the Australian people’. Its main tool to achieve this is by raising or lowering interest rates. Relatively high interest rates will strengthen the Australian dollar (AUD) and vice versa. Other RBA tools include quantitative easing and tightening.

While inflation has always traditionally been considered a negative factor for currencies as it lowers the value of money in general, the opposite has actually been the case in modern times with the relaxation of cross-border capital controls. Moderately higher inflation now tends to prompt central banks to raise interest rates, which in turn has the effect of attracting more capital inflows from global investors looking for a profitable place to keep their money. This increases demand for the local currency, which in Australia’s case is the Australian dollar.

Macroeconomic data measures the health of an economy and can impact the value of its currency. Investors prefer to invest their capital in safe and growing economies rather than precarious and declining ones. Higher capital inflows increase aggregate demand and the value of the domestic currency. Classic indicators such as GDP, manufacturing and services PMI, employment and consumer sentiment surveys can influence the AUD. A strong economy may encourage the Reserve Bank of Australia to raise interest rates, also supporting the AUD.

Quantitative Easing (QE) is a tool used in extreme situations when lowering interest rates is not enough to restore the flow of credit in the economy. QE is the process by which the Reserve Bank of Australia (RBA) prints Australian dollars (AUD) in order to buy assets – usually government or corporate bonds – from financial institutions, thereby providing them with much-needed liquidity. QE usually leads to a weaker AUD.

Quantitative tightening (QT) is the inverse of QE. It is undertaken after QE when an economic recovery is underway and inflation begins to rise. While in QE the Reserve Bank of Australia (RBA) buys government and corporate bonds from financial institutions to provide them with liquidity, in QT the RBA stops buying more assets and reinvests the maturing principal in the bonds it holds already. It would be positive (or bullish) for the Aussie dollar.