Currency Outlook

The Reserve Bank of Australia (RBA) surprised the majority of the market earlier this month by raising their interest rate target to 5.75%. The central bank cited the main reasons for this stance to be firm global growth, rising commodity prices, indications of stronger Australian demand, firmer lending growth, and some signs of rising price pressures.

It is this underlying improving economic picture that has seen the Australian dollar rally since the beginning of April. It has appreciated over 6% relative to the US dollar. However, the key consideration is what can be deducted from this interest rate decision going forward.

It may be argued that the 25 basis point tightening by the RBA was a one off, an insurance against unfavourable price developments, a pre-emptive strike reducing the risks of a later tightening. However, the RBA is now interpreting the economy in a different way, reflecting its new circumstances.

The new interpretation not only raises the risk of further tightening but also signals that, as far as the central bank is concerned, the best years of the long expansion are over.

The three prior RBA tightenings since November 2003 were all related to the consumer spending boom associated with the doubling of house prices and the acceleration of credit growth. Debate over the changes typically turned on credit growth, house prices, and whether or not the interest rate had yet returned to "neutrality".

However, this is not so in the recent tightening. House prices have been flat for over a year, household consumption growth has halved, and household credit growth is only now picking up after a prolonged decline.

In explaining the most recent tightening the RBA offered several complementary reasons. Global growth is strengthening and higher commodity prices will increase export earnings, incomes and spending.

Domestic spending is growing at a solid pace. Business investment in particular is likely to remain strong and consumer spending is rising again. Credit growth is picking up again after the downturn last year.

GDP growth is expected to increase. Crucially, these influences are adding to inflationary pressures. Also, labour is scarce, raw material prices are rising, and underlying inflation has reached 2.75% sooner than the RBA expected. In the Monetary Policy Statement, the RBA forecasts that demand and output growth will converge over the next year or two "to a pace broadly in line with the growth of Australia's productive capacity".

It also forecasts that core inflation will stay around 2.75% because of the "expected dampening effect of the May policy tightening".

These assurances are consistent with no further increases in the interest rate, but both are quite inconsistent with its forecast that business investment, household spending, and exports will all be increasing over the coming year in an economy with limited spare capacity and a tight labour market, where core inflation is already above the mid point of the target band, and in a climate of strengthening global growth and high commodity prices.

Some of the propositions about growth and demand are contestable. However, the important points are that the RBA thinks they are right and, most important of all, not one of them will change in the next one or two years.

On the contrary, it is expected that commodity prices remain high, export income increase quite a lot, business investment and consumer spending remain strong, credit growth continue around the current pace, and the RBA's preferred measure of core consumer price inflation remain sufficiently far above the mid point of the RBA's target band to risk testing the upper limit.

Predictions indicate that unemployment will remain low, capacity constraints will become central to the economic debate, and the RBA will seriously look at another tightening after it sees second quarter Consumer Price Index (CPI) results next July.

Therefore, by the end of the year the interest rate will most likely be 6%, the ten-year bond rate 6.2%, and the Australian dollar could be higher.

A higher Australian currency is likely, providing the market perceives the improving economic picture and inflation-reducing higher cash rate, as an adequate incentive against the rising current account deficit.

The predicted growing current account in 2006/07, which is already at highly unsustainable levels could be the driving force that prevents further Australian dollar strengthening as the year proceeds. In the short/medium term, there is a risk that it could counteract the attractiveness of higher interest rates and the strengthening in the real economy.

In a world where the regime is switching from being interest rate driven to one that is more cautious of structural imbalances and which is increasingly risk averse, it is difficult to be anything but bearish about the Australian currency longer term, given its tremendous external instability.

Therefore, in the short term the Australian dollar may be able to make gains but its ability to hold onto those gains must be questioned due to the structural imbalances in the Australian economy.