Will the Reserve Bank of Australia surprise the markets?
As the market focuses on the Reserve Bank of Australia (RBA) interest rate decision, the question on investors' mind is whether the central bank is going to make the first move and hike interest rates since November 2010.
Investors have strong reasons to argue for a possible interest rate hike above the current 4.75% level. Consumer Price Index (CPI) revealed a higher than expected gain of 0.9% in the second quarter and a 3.6% year on year gain, which is the fastest pace since late 2008. The economic relationship of Australia and China further intensifies the inflation problem. China is Australia's largest trade partner and while China's economy is rapidly growing, Australia suffers from imported inflation. Australia's central bank aims to control inflation between 2-3% over the economic cycle. The rule is simple: When prices escalate, interest rates must go up in order to maintain healthy economic growth. Tightening of monetary policy can control prices as it discourages people and businesses to borrow and increases the rate of saving resulting in lower demand for goods and services. What is interesting to see is whether the latest CPI figures are enough to convince policymakers that it is time to act.
But what is the impact of higher interest rates on the currency? Higher interest rates for a country mean higher rates of return for holding its currency, which leads to higher demand, and thus appreciation in its value. The Australian dollar strengthened to a 30-year high against the US dollar after the CPI data but the weakness of the greenback was already fuelling its rise. The pair edged up as high as 1.1075 from 1.0390 traded in June. If the RBA hike rates by 25 bps then this may help the Aussie extend to fresh highs. In the event where no rate hike occurs, it will all depend on what the central bank has to say to determine AUD moves in the near term.
It is not an easy decision for the central bank. Recent economic data was disappointing triggering the question of whether Australia's pace of growth is slowing. Growth in employment has moderated while housing, retail sales, and consumer spending have all showed disappointing numbers. Also, Eurozone and US debt issues have added to the uncertainty making a rate hike uncomfortable in times of crisis. Whether the RBA announces a change in monetary policy or not we will know on August 2 at 04:30 GMT. What is certain is that volatility should surge leading to large price swings in the Aussie crosses.
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