Australian Dollar Dips after RBA's Lowe Hints Rates Might Not Rise Until 2020

-AUD falls as Lowe hints rates could remain on hold till 2020.

-Says inflation unlikely to hit 2.5% target midpoint until 2020. 

-Unemployment may need to fall even further before wages rise.

© Filipe Frazao, Adobe Stock

The Australian Dollar edged lower Tuesday after Reserve Bank of Australia governor Philip Lowe appeared to suggest an interest rate rise down under could be an even more distant prospect than previously thought.

In a speech about population demographics to the Anika Foundation in Sydney, the governor shed light on the Bank's current views around Australian inflation, which will be set out in full on Friday when the Bank releases its latest set of forecasts. 

Lowe told the audience the Bank expects Australian inflation to remain low over coming years, with the consumer price index set to rise only as far as 2.5% "in 2020", which is the midpoint of the RBA's 2% to 3% inflation target. This could suggest the RBA sees inflation pressures remaining benign right the way through 2019. 

That may have important implications for market expectations around Australian monetary policy, as well as for the Aussie Dollar, and is all the more noteworthy given the RBA's "Shadow Board" has recently said an immediate interest rate rise could be more appropriate than the current policy setting. 

"Over the forecast period, we expect inflation to increase further to be close to 2½ per cent in 2020. In the short term, though, we would not be surprised if headline inflation dipped a little, reflecting declines in some administered prices in the September quarter," Lowe tells the audience. 

This is important for the Aussie Dollar because the RBA has held its interest rate at a record low of 1.5% for exactly two years now, citing below-target inflation and a debt laden household sector that it says is ill-equipped to handle the pressures of higher borrowing costs.

The RBA said Tuesday "the central forecast is for inflation to be higher in 2019 and 2020 than it is currently" but gave no other details. The Australian consumer price index rose to 2.1% for the month of June, although Lowe also warned at the time that it could fall again over coming months. 

Pricing in interest rate derivatives markets, which enable investors to protect themselves against changes in interest rates and provide insight into expectations for monetary policy, implies an August 06, 2019 cash rate of just 1.61%. In other words, markets see only around a 50% probability the RBA will have raised its interest rate from 1.5% to 1.75% by then. 

This could turn out to be either a source of support for, or weigh around the ankles of, the Australian Dollar. Should the implied probability of an August 2019 rate hike rise over coming months, it would lift the Dollar.

But if the RBA's forecasts to be released Friday confirm that it could be much longer before rates rise, that implied probability would fall and put pressure on the Aussie. 

Changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"Looking beyond these short-run dynamics, inflation is still expected to rise as the economy moves closer to full employment. The labour market is gradually tightening and it is reasonable to expect that this will lead to a lift in both wages growth and inflation," Lowe says. 

Lowe and the RBA team upgraded their forecast for unemployment Tuesday, with the unemployment rate now expected to fall as low as 5% during the next two years, down from the previous projection of around 5.5%. Australian unemployment held steady at 5.4% in June.

Lower unemployment and faster wage growth mean greater demand within an economy and higher inflation further down the line, so Lowe's projection of a greater fall in the jobless rate over the next two years should be positive for market expectations of inflation and interest rates. 

However, he also suggested the unemployment rate may need to fall further than was previously expected before wage and inflation pressures begin to pick up, telling the audience 5% is "conventional estimate of full employment in Australia, but it is possible that we could go lower than this." 

"The timing of any future change in interest rates is dependent upon the speed of the progress that is made in reducing the unemployment rate and having inflation return to around the midpoint of the target range on a sustained basis. If we were to make faster progress than we currently expect, any future increase in interest rates is likely to be earlier. Conversely, slower progress would likely see a longer period without an adjustment," Lowe says, Wednesday. 

The Aussie has long enjoyed support from interest rates that were typically higher than those elsewhere in the developed world, although it no longer has any interest rate advantage over the US and Canadian Dollars, while the UK-Australia yield gap is also narrowing now the Bank of England has raised interest rates twice in the last year.

The deterioration of the outlook for Aussie interest rates, at a time when the US Federal Reserve and other central banks are raising their own rates, has incentivised investors to sell the Australian Dollar in favour of buying Pounds, US Dollars and other currencies.

As a result, the Australian Dollar has fallen 5% against the US Dollar in 2018, 1% against Pound Sterling and 1.1% against the Canadian Dollar, although it has really decline by more than this given the currency had actually risen by a similar amount during the first quarter of the year.

The AUD/USD rate was quoted 0.14% lower at 0.7415 Wednesday and the Pound-to-Australian-Dollar rate was also down 0.15% at 1.7407. 

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