Australian Dollar Facing Headwinds from a Dovish RBA as Other Central Banks Push North

The RBA's downbeat assessment of Australian inflation prospects has dampened interest rate expectations and is weighing on the Australian Dollar.

The Australian Dollar could face mounting headwinds over the coming months after the RBA took an ax to its inflation forecasts Friday, suggesting an interest rate rise remains a long way off down-under, at a time when other G10 central banks are looking to push their respective benchmarks northward.

November's Statement on Monetary Policy -  a quarterly report - shows a Reserve Bank of Australia growing more pessimistic on the outlook for inflation. 

The RBA now forecasts headline inflation to sit at 1.75% for 2017 and for 2018, before returning to the lower bound of its 2% - 3% target in the 2019 year.

These are substantial downgrades on the RBA's projections in August, which had envisaged a return to the lower bound of the inflation target as soon as 2017, but certainly within 2018. The earlier forecast for 2019 placed headline inflation comfortably within the 2% to 3% band during that year.

The release of the report has significant implications for the RBA's future interest rate decisions, which in turn will impact on the Australian Dollar.

"We are now assessing a central bank which is expecting that it will undershoot its core inflation target for another year and that even one year out, inflation will still be at the bottom of the target zone," says Bill Evans, Chief Economist at Westpac.

Friday's report was the main factor leading the Aussie Dollar to weaken against the US Dollar, with the AUD/USD rate falling 0.26% to 0.7661 during the London session, while the Pound-to-Australian-Dollar rate rose 0.72% to 1.7293.

The November bundle of inflation forecasts are notable because it is price pressures that central banks are seeking to contain when they raise interest rates. Currencies rise and fall, in a large part, as a result of changes in interest rates and evolving expectations around such changes.

Higher interest rates strengthen a currency by attracting greater inflows of capital from foreign investors seeking to park their money where it can earn the most interest, and vice-versa for lower interest rates.

The downward revision to inflation in November's statement indicates the Reserve Bank expects to have less incentive to raise interest rates over the coming years than was the case just three months ago. 

"It is our view that the decision to lower the forecasts to below the bottom of the band in 2018 and at the bottom of the band in 2019 has significant policy implications," says Westpac's Evans.

RBA Nudges its Growth Forecasts Lower

Apart from lowering its inflation forecasts, the RBA also nudged its GDP growth forecasts for the Australian economy a fraction lower.

Australian economic growth will be around 0.25% lower than previously anticipated in a couple of quarters between now and the end of 2019 but the economy should still average in excess of 3% growth for 2018 and subsequent years. 

"The bank also has revised down its forecast for the recovery in average earnings, which have even undershot the admittedly weak wage price index, probably reflecting a rebalancing in the jobs mix to low paid jobs," adds Westpac's Evans. "Spending could be restricted by high household indebtedness and changes in wealth. With house prices now losing momentum particularly in Sydney, wealth perceptions may constrain spending." 

In normal circumstances a prolonged inflation undershoot such as that described by the RBA and Westpac would be more likely to see a central bank cut interest rates, rather than raise them. However, caution due to previous cuts in 2016 triggering a surge in the already overheating house market, "will temper any inclination to cut again," says Evans.

Despite all of the noise made by the market over reduced inflation forecasts, the RBA remains broadly optimistic in its outlook for the Australian and global economy.

It said it expects that a stronger Australian labour market should lead to a pick-up in wages with time, even though a change in macroeconomic trends has lessened the sensitivity of wages to changes in labour supply so that a tightening labour market does not always lead to higher wages as soon as it did in previous economic cycles.

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