Australian inflation data

Discussion and Analysis by Charles Porter:

There were high hopes for Australian Consumer Price Index inflation statistics released in the early hours of yesterday morning. The data released bucked the trend emanating from Australia this month. Showing under-expectation inflation, year-on-year inflation within the Australian economy fell short of the previous release. With monetary policy steadfast at record lows, stagnating inflation, the primary mandate and target of the Reserve Bank of Australia, pushes a potential rate hike even further away.

The Consumer Price Index (CPI) inflation report showed that the year on year change in the price level was 1.8%. This is below the target rate of inflation of 2% that the Reserve Bank of Australia is bound to. The Australian Bank chooses to target analytical permutations of the raw basket-of-goods data that the CPI represents. Under the title of ‘trimmed mean’ and ‘weighted median’ these two decision-leading variables were comparably underwhelming. The announcement hurt the value of the Aussie Dollar across the board, losing an indicative 0.5% against the US Dollar.

As with most worldwide data releases that we have seen in recent months, the reason for the shock devaluation of the Aussie Dollar is intrinsically linked to monetary policies. The inflation rate, being the target indicators upon which the mandate of the Reserve Bank is constructed, has an elevated impact upon exchange rates. The relationship exists because an increase in the inflation rate implies that a future or imminent increase in the target rate of interest issued by the central bank is more likely. The inverse is also true.

The interest rate, in turn, has two sides to the same coin. On the one hand, it dictates the cost of borrowing – how easy it is for economic agents to get hold of credit. On the other, it represents the reward for saving and, in turn, the reward for investment. Increasing the interest paid upon deposits creates an incentive for capital to flow towards the hiking economy. The increase in the money demand, given a stable and likely constrained money supply with a higher opportunity cost for borrowing, means that the new price level clears the market at a higher level. In short, the price and value of the economy goes up with higher rates of interest.

As mentioned above, the inflation rate was not only expected to hold at the previous rate of change, it was also expected to pick up. Inverting dominant market expectations, the actual data release fell short of previous results by 0.1%, falling even shorter of economists’ consensus forecasts. The exchange rate change represents a pricing out of some of the probability of an Australian rate hike.

The probability and upside potential to the Aussie Dollar from an interest rate hike may well have been overpriced. Despite an underlyingly Dovish central bank, month-to-date hard and soft data releases have been strong and signalled an Australian accession to the strengthening global recovery. The confidence value to a trend-breaking interest rate hike is almost of comparable value to the return upon saving and investment itself.

At face value, considered outside of its monetary policy setting, the rate of inflation only represents the erosion of value of one unit of domestic currency with respect to a basket of consumer goods over a given period of time. Therefore, above expectation or excessive inflation would be supposed to deteriorate a currency. The fact that we see the opposite should affirm in any observer the importance of monetary policy to exchange rates.

Heightened interest in an Australian interest rate hike in the past few months has been stifled by monetary policy decisions and press conferences signalling the Reserve’s dissuasion from a rate hike. With the release of CPI inflation, hard data has now taken the side of Dovish monetary policy. Future developments within hard data will be watched with extreme interest whilst the Reserve is certain to abide to a no-hike decision for now.