RBA keeps rates on hold. Was this the right thing to do?

The RBA interest rate decision to hold rates on hold was perceived as extremely bearish by the AUD/USD exchange rate, which broke towards new lows for 2018. The Australian dollar started the year on a solid note, but the past few months erased all gains because of the broad-based US dollar strength. At the time of writing, the Aussie is down around 1.3% since the beginning of the year.

We haven’t seen an adjustment to the interest rate since August 2016, and according to many Wall Street specialists, the RBA is less likely to act until mid-2019. The RBA benchmark interest rate currently stands at 1.50%.

The RBA hasn’t said anything to mention or suggest that they’re going to change their interest rate policy. The RBNZ and the Bank of Canada, both high-yield commodity currencies, which are in the same group as the Aussie, have taken a distinctly hawkish stance.  For example, the BOC has already hiked rates four times since the middle of 2017, which gives us a very diverging monetary policy, and the RBA finds itself right in the middle.

The RBA came out more dovish than expected during the last interest rate decision.  As was to be expected the AUD/USD exchange rate dived and now it’s challenging the 2017 low. The Australian economy has positive things going for it, however.  The unemployment rate, which is sitting at around 5.4%, the lowest level since November 2017. The RBA forecast the unemployment rate to slide to 5% by 2020. Broadly speaking the outlook looks very positive.

AUD/USD August 2018

The AUD/USD challenging the 2017 low following the interest rate decision.

A strong labour market, by itself, is not enough for the RBA to hike rates. The Australian economy still struggles to see a pick-up in inflation. The Australian inflation rate is still not in the 2% to 3% target range that the RBA is expecting before to have some confidence to hike interest rates. What set the bearish AUD/USD tone was precisely the downgrade in the inflation outlook. The Reserve Bank of Australia sees inflation slowing down to 1.75% by the end of 2018, down from its previous 2% inflation outlook. The most recent inflation reading showed prices rising by 2.1%, but inflation was below 2% for most of the last three years.

The trade war between the US and China and other major trading partners has recently intensified which has added additional negative pressure on the Aussie. The RBA has also acknowledged that rising trade protectionism is damaging to global growth. Due to the high risk that the trade war can have on the global growth, I feel that the RBA has taken the right decision to keep the cash rate on hold.

What should we expect for the year ahead?

The commodity prices are also likely to drive the exchange rate in the year ahead because they are a more critical fundamental driver for the Australian dollar. It is not just Gold that has lost some of its shine, but we also saw others metals like iron ore and copper prices impacted by protectionist trade setups.

Australia is the world’s largest iron ore producer and exporter and it’s the 5th largest global copper producer. Australia is also the second largest gold producing country, and these metals have a great contribution to Australia’s economic growth and prosperity.

Both the inflation outlook and the weakness in the metal market gives no reason to the Reserve Bank of Australia to increase interest rates in the short term. However, over the longer period, the RBA will be forced to hike interest rates to align itself with the other major central banks that are pursuing tightening monetary policy.

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