The RBA often looks at what the US Federal Reserve is doing before making its cash rate call. But why?
The RBA has thankfully given us a drama-free month by holding the cash rate at 4.35%, for the fifth time in a row.
Eight times a year, the RBA sits down to look at inflation figures, unemployment rates, and a range of other factors when it makes its cash rate call.
As part of those ‘other factors’, the RBA also takes a sneak peak at what’s happening with interest rates in other parts of the world.
You know, kinda like how a chef might peek at other chef's recipes to get a dash of inspiration. And the chef extraordinaire around the world is…you guessed it… the United States.
The US Federal Reserve
The US cash rate is effectively the world’s “benchmark” interest rate. So the way that their central bank (aka Federal Reserve) handles interest rates impacts how Australia’s central bank, the RBA handles interest rates too.
The central bank in the US works largely the same way as the RBA does in Australia.
Like the RBA, the Federal Reserve meets eight times a year to assess the US economy, and make decisions on the cash rate to keep the economy in check.
And when the Federal Reserve bumps up their cash rate, it puts pressure on the RBA to do the same.
Because here’s the thing: when interest rates move, they don’t just impact the cost of borrowing, they impact exchange rates too.
And the wider the gap between the interest rate set in the US and the interest rate set in Australia, the weaker the Australian dollar becomes.
How interest rates impact the Aussie dollar
The general rule is:
That’s assuming all else stays equal.
If Australian interest rates go up, Australian savings accounts and other interest-paying assets like government bonds offer a better return to both domestic and foreign investors.
This makes the Aussie dollar more attractive compared to other countries, and pushes up its value.
On the other hand, if the Australian interest rates are low, especially when compared to advanced economies like the US, Europe, or Japan, then Australian assets can become less attractive to investors.
The demand for the Aussie dollar drops, and so does its value.
And when that happens, it becomes more expensive to import goods into the country, which can also have the effect of worsening inflation.
That’s why the RBA needs to keep its eye out on what the Federal Reserve is up to.
It needs to bring down Australia inflation, while also keeping the value of the Australian dollar in check.
But why is the Aussie dollar so low compared to USD if higher interest rates should increase its value?
Well, the rule between interest rates and exchange rates doesn’t always hold up. As we said before, this rule holds up if all else stays equal.
But exchange rates are pretty complicated and there are a bunch of factors that impact them like inflation, political and economic stability, government debt, and more.
Comparing the US and Australian cash rates
So when the RBA decides on the interest rate, it plays a balancing act because interest rates have far reaching implications throughout the economy.
Some are direct, like higher interest rates for mortgage holders. Others are indirect, like the impact on exchange rates.
If the RBA follows the Federal Reserve blindly with increases and decreases, it risks putting too much pressure on Australian households, and a cascade of homeowners might default on their mortgages.
But if the RBA doesn’t match the Federal Reserve to some degree, it risks pushing down the value of the Australian dollar and increasing the cost of importing.
The Australian dollar is currently at $0.66 USD, down from a high of $0.72 in January 2023. But some of the major banks are expecting things to turn around. NAB, ING, and Westpac are all predicting the Australian dollar to rise above $0.70 before the end of the year.
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