Australian dollar behaviour could cause inflation problems – Tyndall

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With the Australian dollar undergoing a sea change in its behaviour since the global financial crisis, the Reserve Bank of Australia’s ability to manage inflation has become more challenging, says Roger Bridges, head of fixed income at Tyndall AM.

With the Australian dollar undergoing a sea change in its behaviour since the global financial crisis, the Reserve Bank of Australia’s ability to manage inflation has become more challenging, says Roger Bridges, head of fixed income at Tyndall AM.

“During the crises over the last few years – most notably the European sovereign debt woes and US’s credit rating downgrade – the dollar held up remarkably well compared to its historical performance in times of proportionately less volatility.

“There are several reasons for this, including China’s strong demand for our commodities; loose overseas monetary policy, with relatively tight policy here and a high cash rate; and our solid AAA status at a time when other countries around the world are losing theirs.

“Australia is likely to retain its AAA status, but concerns over China’s slowing economic growth and looser domestic monetary policy mean that two of the props for the dollar have been weakened.

“This has serious implications for the economy – while a lower dollar (although still historically high) may ease some of the pressure on an economy that relies heavily on trade, it will affect inflation which means the Reserve Bank of Australia (RBA) will need to think hard about its next interest rate decision if it is to control inflation effectively.

“Currently, the Australian bond market is pricing in large rate cuts (to a record low of almost 2.5 percent as of mid-May).

“This appears to be driven more by external factors than state of the domestic economy – with Greece’s ongoing issues and disappointing Chinese data for April, there has been flight to safety buying in Australian bonds. However, domestic data remains reasonably solid.

“In addition, if the Australian dollar weakens further or stays below parity for a prolonged period, then we are likely to see inflation spiking up again. This would mean a moderation in expectations for RBA rate cuts and that we should start seeing a rise in bond yields from their current record lows,” Mr Bridges said.

He added that the RBA’s scope for using monetary policy effectively may not be as great as many believe.

“We have recently seen looser monetary policy in Australia, coinciding with increasing concerns over the latest failed Greek elections and, perhaps more importantly, a raft of disappointing April data out of China. This led to a sharp fall in the Australian dollar, such that it fell below parity with the US dollar in mid-May for the first time since December 2011.

“It has generally been assumed that if China were to slow markedly, then the RBA has ample room to provide support to the economy through monetary policy (i.e. cash rate cuts). But if the Australian dollar comes down at the same time, which is the likely outcome, this would be liable to push up inflation faster than it did historically, reducing the RBA’s manoeuvre room.

“Although the recent CPI figure was lower than expected, an examination of the underlying data shows that the decline comes from the higher Australian dollar and a sharp fall in food and vegetable prices, which are unlikely to continue dropping at such a rate.

“The higher dollar has acted to suppress inflation overall due to the huge decline in tradeables inflation, making international goods much cheaper. Should the dollar fall on the back of concerns over China and looser monetary policy, this inflation will start spiralling up.

“This will restrict the RBA’s ability to cut rates much further for fear that inflation will get out of control. The RBA will need to be very careful in balancing all the various factors and proceed cautiously regarding any cash rate cuts,” Mr Bridges said.

Tyndall AM offers Australian equities, international equities and Australian and global fixed interest funds and multi manager investments to retail and institutional investors in Australia.  It has over A$22 billion in funds under management (as at 31 March 2012).  It is a wholly owned subsidiary of Nikko Asset Management Co., Ltd., the largest regional asset manager headquartered in Asia with approximately A$152 billion in funds under management (as at 31 March 2012).

 

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 For more information please contact:

Roger Bridges – Phone: 02 8072 6350

     31 May 2012