Australian Treasurer Jim Chalmers has warned the Reserve Bank of Australia’s hesitancy to raise interest rate in line with the U.S. Federal Reserve could depreciate the Australian dollar – a paradoxical situation which would spur inflation higher and force the RBA to raise the cash rate much higher than expected.
“When there’s a big and widening gap between US interest rates and Australia, which is putting downward pressure on our currency, that makes imports more expensive… And that has implications for inflation – that’s the mechanics of it,” the treasurer told reporters in Canberra just ahead of a trip to Washington to attend the IMF & World Bank annual meetings.
“We are headed for a substantial global downturn, and we won’t be immune from that”, he added.
“It’s increasingly becoming the expectation of the global economic community that we could be facing what would be the third, substantial global economic downturn in the past decade and a half,” he said.
In an unexpected move, the RBA broke with other central banks around the world by slowing the pace of rate hikes – lifting the cash rate by 0.25 percentage point, half of what markets had expected in terms of the serious efforts to curb red-hot inflation and cool off inflation expectations.
The dovish attitude and inadequate action sent the Australian dollar (AUD) plunging to new record lows and to settle at the $0.62 level this week.
Meanwhile, the Fed raised its benchmark interest rate by 0.75 percentage points to 3%-3.25% and signaled plans to lift by another 1.25 percentage points before the year-end to 4.25-4.5 percent. Higher rate pushes domestic currency up. Higher USD means lower AUD.
In his usual post-board meeting statement, RBA governor Philip Lowe still said inflation in Australia remained “too high” and predicted inflation to reach 7.75 percent this year (didn’t say how), before dropping to just over four percent in 2023 and about 3 percent in 2024.
A lower exchange rate makes imported items like fuel, clothes, furniture, electronics more expensive, leading retailers to raise prices in Australia. It soon lifts up prices of domestically produced items too because of components, fertilisers, fuel, machinery, spare parts, maintenance, transport etc. becoming more expensive even if they remain at the same price at the international market. This means higher inflation in Australia.
Prices also rise because people expect them to. This is called inflation expectations. Plunging domestic currency is one of the factors contributing to these expectations. Again, this means higher inflation in Australia.
Higher inflation means more rate hikes. A late response means more rate hikes. And sometimes, unnecessary ones. Unfortunately, the RBA is falling behind again, bowing to the political pressure not to let house prices drop.
Besides inflation, the RBA’s dovish outlook will likely trigger rapid capital flight, the outflow of capital from Australia due to the lower interest rate than the US, AUD instability and depreciation, higher risks and lower return on investment.
If parking their money in the US means lower risk, protection against currency depreciation, higher interest earning, why would financials institutions – whether multinational or Australian -, including large banks keep, lend or invest their money in Australia?