RBA changes tune on cash and exchange rates

The Reserve Bank of Australia (RBA) closed the door on further interest rate cuts today, as it held the cash rate at 2.5% and stated that "on present indicators, the most prudent course is likely to be a period of stability in interest rates".

This was one of two main features in today's monetary policy statement. The second concerned the exchange rate, which the central bank noted had "declined further" and could "assist in achieving balanced growth in the economy".

This is a marked change in tone. The RBA has repeatedly expressed its concerns over the strength of the Australian dollar in the past six months. Governor Glenn Stevens has, on numerous occasions, described the exchange rate as "uncomfortably high".

The Australian dollar climbed to US$0.97 in October, but has since dropped by around 10 cents to US$0.87. Suktae Oh, a Societe Generale analyst, observed that "the RBA appears to be content with the level the Australian dollar has now reached".

There are side-effects to the weakening currency, however, including "higher than expected inflation" last month. Annual CPI inflation increased to 2.7% in December, 20 basis points above the central bank's estimate, which it attributed to the "faster than anticipated pass-through of the lower exchange rate".

Moreover, the central bank has now revised its forecasts for 2014 and 2015. "Inflation is expected to be somewhat higher than forecast three months ago, but still consistent with the 2–3% target over the next two years," according to the statement.

In November, when its latest forecasts were released, the RBA predicted that inflation would rise to 2.75% in June 2014. Its comments today suggest that inflation could rise out of the target range at some point this year, before falling back in 2015.

"We read this as indicating that the RBA has a very similar inflation projection as ours, which is for annual rates above 3% for at least the first half of 2014 and perhaps also the third quarter," Oh said. "In other words, the RBA is proving yet again that it really is an inflation-targeting central bank (and not one that targets nominal GDP)."