Why RBA has to hike 50 bps on Tuesday

Australia’s central bank may have no option but hike interest rates on Tuesday and in the subsequent months in order to curb inflation, give a leg-up to the Australian dollar and preempt potential capital flight as the US Federal Reserve keeps raising rates.

In addition to inflation and consumer spending problems, plunging Australian dollar and changing overseas capital markets are mounting pressure on Reserve Bank of Australia (RBA) to push up rates.

The Fed announced it was raising its key rate by another 0.75 bps, lifting the target range to between 3% and 3.25%, the highest level in almost 15 years as it struggles to rein in red-hot inflation in the world’s largest economy.

RBA will either follow suit to prevent AUD from weakening further against the US dollar or risk capital flight and further inflation from imported services and goods such as petrol.

Lower domestic rates against the US benchmark range and waning domestic currency have traditionally triggered capital outflow (such as more than two decades of stagnation in Japan) – a process when assets or money rapidly flow out of a country as investors see better opportunities abroad (e.g. higher rates). This leads to dramatic decreases in the purchasing power of the country’s assets and makes it increasingly expensive to import goods and acquire any form of foreign equipment, e.g. medical facilities.

Central banks in nearly every country are facing similar pressures as they raise rates to combat their own inflation problems and support their local currency against the surging USD.

Futures markets have also recently edged up their predictions that RBA will lift the cash rate past the 3% mark by the year-end and keep higher, likely near 4% for longer than expected. Inflation outlook has also been upgraded to just under 8%, which is and will stay outside the RBA’s 2%-3% target band for longer.