The US Dollar is much stronger - how will it impact the Australian economy?

RBA Assistant Governor of Financial Markets Christopher Kent has spoken on Australia's inflationary pressures and rate increases at CBA’s Global Markets Conference in Sydney, noting Australia's currency depreciation hasn't been as significant as other economies.

Over the course of this year, the US dollar has appreciated by 12% in trade-weighted terms, a significant appreciation against the currencies of other advanced and emerging economies.

Relative to many other economies, including Australia, the US has seen a rapid rise in interest rates.

The depreciation of those economies against the US dollar is expected to add pressure to already high rates of inflation, resulting in a rise in the prices of imported goods and services.

"While it has depreciated significantly against the US dollar – falling by 14% this year – in trade-weighted terms, the Australian dollar has depreciated by only 2% over the same period," Mr Kent said.

"A rough rule of thumb from our models suggests that the level of the Consumer Price Index (CPI) will be higher by only around 0.2% in total over the course of a few years.

"The decline in the Australian dollar over recent months also accords with the fall in the differential between interest rates in Australia and those of major economies."

Mr Kent also noted that commodity prices overall have declined over the past few months, but they remain around the levels seen at the turn of the year.

"Again, much of this reflects the rapid and prospective rise in the policy rate in the United States, which is larger than for the cash rate in Australia based on market expectations," he said.

"Higher interest rates in the United States will, in time, help to stem the growth of US demand for goods and services.

"The US economy accounts for about 25% of the global economy - based on 2021 nominal GDP in US dollar terms - so an easing in demand pressures in the United States will help to ease a noticeable portion of global demand."

The cash rate vs inflation vs currency conundrum

In August, the RBA announced its predictions for Australia’s inflation rate, forecasting it to peak in December at 7.8%.

Since kicking off the cash rate rise by 25 basis points in May, the Reserve Bank's increase in the rate target has been sizeable and rapid, with rates rising by 50 basis points consecutively between June and September.

The trend was then bucked in the RBA's October meeting, where the Board lowered the rate rise to 25 basis points.

However this opened the door for a slower but more elongated tightening process from the RBA, as the Board continues to establish a more sustainable balance of demand and supply on the cusp of a tightening labour market.

"The size and timing of rate increases in Australia will depend on incoming data – including the response of household spending to the tightening in financial conditions that is still working its way through the system," Mr Kent said.

Mr Kent's speech also highlighted that Australia's wage growth had been low over a number of years prior to the pandemic, with actual wages growth being much weaker than the Bank had forecast.

"Looking at the growth of the Wage Price Index (WPI) – annual wages growth of around 2% had become normal, while 3–4% growth was the norm in the 15 years or so prior to the end of the mining investment boom," he said.

This comes off the back of the Fair Work Commission's increase to minimum wages, which came into effect on 1 October.

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