The beats of their own drums
Australia has been later to the inflation surge and disinflation than peer economies. So the RBA will be later than its peers to cut rates, too. Central banks can move policy according to domestic needs rather than be led by the Fed. Exchange rates are likely to respond.
The world is entering 2024 with global inflation declining, but still high. Goods price inflation has retreated as pandemic-related disruptions to supply chains have resolved. Services inflation is still high in many economies but it, too, is decelerating as domestic economies and especially labour markets soften. This means that, in most cases, a near-term rebound in domestic inflation is not a material concern.
Markets are looking ahead to the point that central banks can start cutting interest rates from current contractionary policy stances. This is likely to happen once they are confident inflation will return to target soon. They do not have to wait until inflation actually reaches the target. This is an implication of the lagged effects of monetary policy: central banks need to be forward-looking, reacting to shifts in the outlook and the risks around that outlook, and not necessarily to the latest data surprise.
Several major central banks have started communicating publicly about the timing of future rate cuts. In some cases, including the Federal Reserve and the ECB, this has been to hose down market expectations that these policymakers consider overly enthusiastic. Nonetheless, these policymakers are acknowledging that rate cuts are coming within the year.
Australia has been later to the inflation surge and disinflation than peer economies. We were later to open up after the pandemic, and for institutional reasons, some of the other supply shocks have had a more drawn-out effect here as well. For example, while Russia invaded Ukraine in February 2022, it was July 2023 before Australian households started seeing the effects of higher energy prices in their electricity bills. The extraordinary surge in labour supply here has both delayed and dampened the upswing in wages growth; our wage bargaining institutions have played a role here as well.
As a result, the RBA will be later than its peers to cut rates, too. We currently expect that the RBA will reach that point around its September meeting. This is noticeably later than market pricing for the Fed or the ECB.
We are often asked whether the RBA (or the central bank of any other small open economy) can operate on such different timing. The answer is that they can. When the exchange rate floats, monetary policy can move quite independently in response to domestic needs. Global factors will have a common influence on the actions of all monetary policymakers, as we saw during the pandemic. But as long as the exchange rate floats, central banks can respond to the domestic implications of that common factor, not to the responses of their larger counterparts.
An examination of recent history makes this clear. Central banks do move their policy rates on different timetables. For example, in early 2008 and in the mid 2010s, the RBA and the Federal Reserve were moving in opposite directions. The domestic situations differed and so did the monetary policy response.
The floating exchange rate regime makes this possible because the exchange rate then adjusts to absorb the shifts in investment flows attracted by changing relative yields. Yes, higher rates relative to the major economies attract capital flows, but they also push the exchange rate up. This makes the trade more expensive, and so less attractive. So there are limits to the speculative capital flows that will be induced by the interest differential, if that is the kind of thing that worries you.
That exchange rate adjustment is in fact part of the transmission mechanism of monetary policy and works to support what the central bank is trying to achieve. If the rate differential increases (or in the near term for Australia, becomes less negative than before), and the exchange rate appreciates, that tends to put downward pressure on the domestic prices of internationally traded goods and services. This includes domestically produced tradable items, which must compete with foreign producers. The result is lower inflation, at least for a time.
There are situations when this adjustment is uncomfortable. But this is more of an issue for emerging markets, where sudden shifts in capital flows can cause market disruption. Countries with dominant trading relationships with another economy might be reluctant to see too much appreciation against its currency, because of the impact on exporting businesses. That isn’t the situation for Australia in relation to the United States.
We therefore do not see any barriers to the RBA operating on its own timetable, driven by its own view of the domestic inflation outlook, different from that in the United States. This timing difference also underpins our view that the Australian dollar will appreciate over 2024, especially against the US dollar.
Of course, if everyone expects central banks to act as we expect, that will already be priced into exchange rates and there is no further impetus for them to move. When we talk about year-end expectations for an exchange rate, though, it’s a more subtle story of the balance of risks and where markets are more likely to be surprised relative to current pricing. Once the US Fed starts to move, that source of uncertainty is removed – and shifts in beliefs about RBA timing will be the remaining source of pricing action from interest differentials.
There are many risks around this central view, including geopolitical events and the headwinds to growth in China. Short-term movements in exchange rates can be driven by risk sentiment. In Australia’s case, the outlook for key commodity prices also tends to shape the outlook for the exchange rate. The outlook for both interest and exchange rates will always evolve with events.
The important thing to remember is that the rates outlook in each economy depends on the economic outlook in that economy. Central banks don’t have to follow the Fed mechanically. They can work to the beat of their own drum.
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