RBA prefers weak AUD; additional rate cut possible if currency continues to strengthen

The Australian central bank, Reserve Bank of Australia, had reacted immediately in May by lowering its key rate by 25 basis points to 1.75 percent, as expected widely. The cut in rates was also a response to the noticeable strengthening of Australian dollar since the beginning of 2016 when the market did not respond to RBA's warnings that stronger AUD was exerting pressure on the outlook of inflation, noted Commerzbank in a research report.

The central bank looked very optimistic in June that if interest rates continued to be the same, it would be possible to attain sustainable growth and return of inflation to the target corridor. But, in the July meeting it had to back pedal, said Commerzbank.

After the uncertainty resulting from the unexpected Brexit vote, the RBA initially intends to gather additional information before coming to a decision on a possible further adjustment of monetary policy. Given the persistent subdued inflation pressure, an additional rate is still possible, especially if the Australian dollar continues to appreciate.

The strong AUD continues to be a thorn in the central bank’s side. The Reserve Bank of Australia is worried that a strong currency might “complicate” the economic adjustment process. A weaker currency might assist in offsetting the adverse effects of declining commodity prices that has exerted significant pressure on Australia’s terms of trade.

Even if commodity prices have rebounded slightly, they continue to remain below the 2014 levels. The Australian central bank projects that prices of iron ore and coal will continue to be affected from subdued Chinese demand for some time.

Weakness in China’s economy continues to be one of the most significant risk factors, according to Commerzbank. If China’s economic situation deteriorates and if economic risks experience a hard landing, the Australian central bank might cut its key rate again, said Commerzbank.